Efficient Diversification is a Moving Target

Efficient Diversification is a Moving Target

Posted on October 22, 2019

Market State- MS 2 (Bullish): The S&P 500 remains in Market State 2, and near the top of its recent trading range.  The Market has been moving sideways over the last few months, having yet to break to the upside or the downside.  Additionally, while the S&P 500 is in Market State 2, other indexes have their own Market States.  The table below shows various styles/indexes with their Market States:
 
Large Cap Value Market State 2
Large Cap Growth Market State 2
Mid Cap Value Market State 9
Mid Cap Growth Market State 3
Small Cap Value Market State 10
Small Cap Growth Market State 9
Emerging Markets Market State 7
 
Canterbury Volatility Index- CVI 71: With the market’s trading range that has occurred over the last few months, we have seen declines in volatility and the market reaching a relative peak, be followed by spikes in volatility.  The chart below shows the S&P 500, along with Canterbury’s short-term volatility index.  You can see that following each relative peak, there has been a spike in short-term volatility.  Based on this pattern, it would not be unexpected that we see another spike in short-term volatility.
 

Comment
All liquid traded securities will go through both bull and bear markets.  Every asset will have a time when it is in favor, as well as a time when it is out of favor.  Traditional portfolio management has often failed to take this fact into account. What has been typical in investment philosophy is the concept buying, holding, and rebalancing a fixed asset allocation based on an investor’s risk tolerance.

Diversification is a crucial aspect of portfolio management.  Unfortunately, diversification in the past has meant buying and holding a wide array of assets that are historically not correlated.  The idea is then that while some assets are going down, they will be offset buy assets that are increasing in value.  An example of a traditional, fixed portfolio can be seen below.  The allocation of this portfolio a “conservative” 60% stocks and 40% bonds. 


Source: CIM

You can see that the above portfolio holds a range of different index funds ranging from US equities, to international equities, international debt, and US debt, as well as gold and real estate.

As mentioned in the “Market State” segment of this update, asset classes like small cap growth, small cap value, and emerging markets, are all in transitional or bear markets.

There have been many different time periods where the traditional method of diversification would have failed (bear markets).  During bear markets, assets often become correlated and a traditional portfolio loses all of its diversification benefit.  Using Canterbury Analytics, with the help of an online tool called “Portfolio Visualizer,” we can backtest this hypothetical, traditional portfolio back to the 2008 financial crisis.

During the 2008 financial crisis, this traditional, “conservative” portfolio would have lost -37%.  I am not sure what your definition of conservative is but losing 37% does not meet my definition.

You can see from the table below that this “diversified” portfolio would have had virtually no diversification
 
Conservative Portfolio During 2008 Financial Crisis
Asset Return
US Large Cap -52.16%
US Small Cap -51.73%
International Developed stocks -59.72
Emerging Markets -61.91%
Emerging Market Bonds -20.76%
Securitized Bonds 3.68%
High Yield -35.24%
US Intermediate Treasuries 10.97%
Investment Grade Bonds -11.19%
Gold -21.61%
Real Estate -68.24%
Source: CIM

Portfolio Thermostat
This brings us to the Canterbury Portfolio Thermostat and Adaptive Portfolio Strategy.  The goal of an adaptive portfolio, like the Portfolio Thermostat, is to maintain portfolio efficiency through all market environments, bull or bear.  Making money means nothing if you cannot keep it.

This is why Canterbury developed the Portfolio Efficiency Score.  Canterbury benchmarks its portfolio against key “internal” metrics, in order to measure portfolio efficiency.  These metrics are Portfolio State, Portfolio Volatility, and Portfolio Benefit of Diversification.  By keeping the portfolio efficient, we have the ability to limit drawdowns and compound returns regardless of market environment.

The Portfolio Thermostat currently has an efficiency score of 90, which makes the portfolio efficient for the current market environment.  The Portfolio Thermostat maintains low volatility and a high benefit of diversification.  Regardless of what the market does with its current trading range, the portfolio should maintain stability due to the diverse set of holdings.

Bottom Line
The market remains towards the upper end of its trading range.  Short-term volatility is yet again declining.  If volatility maintains its current pattern, we may see another spike in volatility.

The main point highlighted this week is why adaptive portfolio strategy is so important. Traditional portfolio management has not methodology to manage the high volatility that comes with a bear market.  As volatility increases, a fixed portfolio will experience less diversification and increased volatility, which could lead to substantial declines.