To help ameliorate the declines experienced during a bear market, the investment community has long advocated diversifying one's equity holdings across various equity asset classes, such as large-cap growth and value, mid-cap growth and value, and international stocks. Yet all the purported benefits of diversification somehow managed to fail spectacularly from late 2007 well into the first quarter of 2009. In fact, despite having their equity holdings distributed across many different types of equity mutual funds and stock holdings, the declines in investors' overall equity portfolio values over the period were unprecedented in the modern era.
If we wish to prevent the re-occurrence of such extreme losses in the future, we must first begin by determining what caused the strategy of diversification to fail. We believe the principal source of the decline in almost every type of equity class can be attributed to the concept of phase-locking.
Phase-locking occurs when generally uncorrelated assets suddenly become synchronized. We saw this firsthand during the recent bear market when companies of all types, sizes, industries, geographies and quality became highly correlated.
So, what was the trigger, or what pervasive influence led all these stocks, across all world markets, to become phase-locked?
There were two common forces: the unprecedented degree of leverage across the financial markets globally, and the extensive uncertainty of the macro-economic developments stemming from a potential collapse of the financial system. Pervasive common forces are akin to a mega-tsunami. When a mega-tsunami hits land, seemingly unrelated physical items like houses, cars and boats are all swept up in the deluge. Likewise, over the past year and a half, a mega-force as powerful as if it rose from the deepest oceans landed on the world stock markets all at once and proceeded to roll over the entire integrated global financial system.
To illustrate this point, we created a hypothetical portfolio comprised of six highly ranked, well-diversified mutual funds across different size and style categories - including growth and value, large and small cap, domestic and international - and then analyzed its performance over the period from September 2007 through March 2009. What immediately became clear is the very similar negative performance pattern all these funds experienced, despite each fund being distinctly invested in only one style and size, and with no overlap.
The conclusion drawn from this is that during bear market periods, the purported benefits of diversification can no longer be relied on as effective. Said in a statistical way, when pervasive common forces rise, the correlations of all stocks tend to rise toward unity. This is, of course, the exact opposite of what an investor desires. An investor wants to have the correlations of their investment holdings decline during a period when pervasive common forces are causing a bear market.
To compound the problem, at the same time that the benefits of diversification seem to have disappeared, another long-held important financial industry rule, the notion of "buy and hold" investing, has also failed. This method of investing, which advocates buying good companies and holding them over the long term, has risen to near scientific validation status. However, the "buy and hold" approach has some underlying assumptions that warrant understanding. "Buy and hold" represents an investing strategy that has a linear relationship with the stock market and accordingly has virtually unlimited downside market exposure. In reality, most investors do not have unlimited risk tolerance, and this creates a major limitation on the strategy's applicability.
At the end of the day, it is the investors who bear all the risks associated with significant market volatility, and too many of them do not truly comprehend its implications. Indeed, in most cases, the risk embedded in the stock market - and, for that matter, virtually all equity portfolios - is far in excess of what investors explicitly state is their risk tolerance.
We believe that when phase-locking occurs again during the next bear market, the odds favor that the future behavior of different equity classes will experience a similar highly correlated, relatively undiversified outcome. Fortunately, there are approaches available that can help mitigate the losses an investor may experience.
One approach is to adopt a convex or nonlinear investment asset allocation plan. We call this approach the Variable Proportion Allocation Mix. In contrast to the "do nothing, stay the course" approach that is at the center of the "buy and hold" strategy, the Variable Proportion Allocation Mix strategy reduces the amount allocated to equities as equity values fall.
Alternatively, a second approach would be to develop a risk-based forecast for the entire portfolio and, assuming a phase-locked level of forecasted correlations, compute how much could be allocated to equities predicated on a two- and three-standard deviation decline. Under the mega-tsunami scenario, an investor can then determine the percentage allocated to equities that can withstand a severe bear market while still remaining within their overall portfolio risk budget.
Both of these approaches, however, require investors to have an effective strategy to re-establish equity exposures to their appropriate levels as soon as one can see a resolution to the pervasive common forces that have caused the bear market.
In the end, investors should understand that pervasive common forces will almost certainly occur again, driving equity volatility higher, while at the same time rising correlations will cause the benefits of diversification to fail. In the face of this, traditional "buy and hold," as well as conventional methods of diversifying one's equity assets across many different types of stocks or mutual funds, will likely be no more successful than what we just experienced. Ultimately, to mitigate unacceptable levels of equity portfolio decline, planning ahead will require a more thoughtful and sophisticated approach than in the past.
Garrett D'Alessandro, CFA, CAIA, AIF, is the chief executive, president and co-investment officer of Rochdale Investment Management, a private-client money manager specializing in personalized portfolio management for high-net-worth individuals and families. For more information, call (800) 245-9888 or e-mail info
(c) 2009 Accounting Today and SourceMedia, Inc. All Rights Reserved.
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