(MoneyWatch) One of my favorite expressions is that because the only truly free lunch in investing is diversification, you might as well eat a lot of it. That still leaves the question: How best to diversify? One strategy that has become especially popular among institutional investors is to diversify into alternative investments, such as private equity and hedge funds. In fact, some U.S. endowments have gone whole hog, allocating as much as 80 percent of their portfolios to alternatives. These strategies typically incur high expenses (such as a 2 percent management fee and a 20 percent performance fee) and are often illiquid, which creates additional risks.
An alternative strategy is to diversify across factors that explain returns. For stocks, the factors include beta, size, value, momentum and newly "discovered" profitability. For bonds, they include term, credit (default) and the carry trade (borrowing, or shorting, a currency with a relatively low interest rate and using the proceeds to purchase, or go long, a currency yielding a higher interest rate). .can all be accessed with relatively low cost, liquid, publicly available mutual funds and ETFs.
The authors of the study "The Tortoise and the Hare: Risk Premium versus Alternative Asset Portfolios," compared the two methods. The study covered the 20-year period 1990-2009. We'll take a look at their findings.
The correlation of many alternatives to equity risk is high. For example, the correlation of hedge funds and private equity to stocks was 0.79 and 0.71, respectively. Thus, most of their returns are explained by the returns to stocks. For REITs and Infrastructure, the figures were 0.59 and 0.58, respectively. On the other hand, the correlation of the size, value, and momentum premiums were 0.27, -0.32, and -0.04, respectively. Even the emerging market premium had a correlation of just 0.14.
Readers of my blog know that I'm not a fan of high-yield bonds. One reason is their high correlation with stocks, which tends to turn even higher at the wrong time. The correlation of the credit premium to stocks was 0.68. That's almost as high as it is for private equity and hedge funds. On the other hand, the correlation of the term premium to stocks was -0.27. And the carry trade had a correlation of just 0.32.
The authors concluded that risk premium diversify more efficiently than alternative investments. They also concluded that the returns of an equally dollar-weighted risk premium portfolio are comparable to those of an endowment portfolio, but with much less risk. On an interesting note, the authors cited two studies which found a simple 1/n diversification strategy (equal weighting the factors you are diversifying across) was as good as any of the other different methods tested.
The two alternative investments that the authors suggested provide diversification benefits were timberland and commodities. Their correlations with stocks were just 0.05 and 0.06, respectively. Even managed futures exhibited correlation with stocks of 0.49.
The bottom line is that while diversifying across factors might not be as exciting or glamorous as investing in alternatives, it's the strategy that's more likely to allow you to achieve your goals.
Ron Bird, Harry Liem, and Susan Thorp, "The Tortoise and the Hare: Risk Premium versus Alternative Asset Portfolios," Journal of Portfolio Management, Spring 2013
Image courtesy of Flickr user Howard Lake.