Furthering the Science of Diversification

Considering the “combined expectations for low asset returns and the unavoidable reality of downside risk in a highly uncertain global political and economic climate,” investors of all types are looking for new ways to diversify their portfolios, according to a new analysis from Willis Towers Watson, “Breaking the Style Box.”

The research suggests institutional investors will likely only be able to achieve “low- to mid-single digit returns on traditional 60/40 portfolios of equities and fixed income” for the foreseeable future. This is driving many to consider new approaches and new exposures, particularly on the risk-asset side of the equation.  

But, as the research points out, there is a “common view that diversification is isolated to equities and means buying equities of different types such as value or non-U.S. This approach may have merit, particularly in a big equity market like the U.S., but in reality, all of those assets’ returns are highly related and tend to be caused by similar circumstances—corporate earnings growth.”

The research suggests a “total portfolio” must be “diversified through the use of multiple return drivers across markets and capital structures, not just multiple listed asset classes … The most prevalent asset classes in U.S. institutional portfolios are all macro sensitive. The problem is they tend to disappoint in stress episodes when they are needed the most.”

Researchers go on to suggest the “belief that a well-diversified portfolio requires several asset classes is another diversification misperception.”

“We’d argue that it’s the quality of your return drivers, not the quantity of asset classes, that makes a well-diversified portfolio,” the paper suggests. “Put simply, the holdings in your portfolio should fluctuate for different reasons and in different environments. This is accomplished by knowing the underlying return driver of a holding. Is it illiquidity, complexity or even implementation? Does the willingness to take risks, or make decisions others cannot or will not due to constraints, drive returns?”

The Willis Towers Watson researchers conclude “it is possible to meaningfully improve many institutional investor portfolios with a small number of liquid and low-cost strategies that, based on our experience, aren’t prevalent in many portfolios today.” These include strategies such as “holdings that simply take a quarter or two to liquidate—a far cry from the decade-long hard lock structures to which many investors are averse.”

The full research report can be downloaded here.