While most of our clients already understand the importance of diversifying their portfolios by including securities from a range of industries, many ask their wealth advisor to provide investment guidance as to how asset allocation impacts diversification and portfolio performance.
While the concept of diversifying across investments is easy to understand, asset class diversification is a bit more complicated.
At its core, the object of asset class diversification is three-fold:
- reduce exposure to risk
reduce fluctuation in returns
capture market returns
Here's why you should add asset class diversification to your arsenal of wealth management strategies.
Why Our Investment Professionals Advocate Asset Class Diversification
Using asset classes to build an efficient portfolio is known as maximum feasible diversification, a two-tiered process that ensures that each asset class:
Has at least a degree of independent behavior (low correlation)
Is itself broadly diversified, containing hundreds of firms across numerous industries
Asset-class funds managed with a passive-style eliminates some uncertainty by achieving average rates of return for the total population of the asset class. How? You get the average by purchasing the entire population – and that’s exactly what a passively managed asset-class fund does. Fees and costs always prevent matching gross rates of return.
And speaking of costs, asset-class passive management costs a fraction of active management, resulting in a minimal spread between your gross and net rates of return. For instance, the Vanguard S&P 500 fund has an expense ratio of only .17%, while the average expense ratio for actively managed funds is 1.5% — more than eight times higher – and that’s not even including all of active management’s (often hidden) costs.
MPT: Financial Strategies and Asset Class Diversification
Asset allocation across several classes follows basic tenants of Modern Portfolio Theory, which analyzes investment strategies based on how different securities correlate within a portfolio. Specifically, asset class diversification supports two basic Modern Portfolio Theory assumptions:
Passive-style managed asset classes avoid unnecessary risk and expense associated with the (futile) strategy of attempting to beat the market
Selecting asset classes with low correlation leads to efficient diversification
Structured asset-class funds are inherently more diversified than actively managed funds. Why? Because the only possible way to beat an average is by selecting from within that population – i.e. incomplete diversification. In contrast, if you select the entire population, you’ll end up with the average, providing the competitive advantage offered by adequate diversification.
Reaching the Final – Most Efficient – Frontier Through Financial Strategies
No, it’s not outer space or the Mariana Trench – the efficient frontier is the best combination of risk and return; this may be the lowest risk for an expected return or the highest expected return for a certain level of risk.
Modern Portfolio Theory tells us that:
If you’re not adequately diversified, you’re not on the frontier
If you’re employing active management, you’re exposed to uncompensated risk, incurring unnecessary expenses and you’re not on the frontier
If you’re moving along the frontier, you’re compensated for taking on more risk with a higher return
But don’t think of the efficient frontier as a precision instrument; rather, it's a graphic representation of the only two ways to increase returns:
moving to the frontier by becoming a more efficient investor
moving along the frontier by (deliberately) taking more risk
The frontier also represents the boundary between the possible and the impossible – you can’t move beyond it. As an investor, you’re faced with two challenges: Reaching the frontier and then determining your comfort level on the boundary. While getting to the frontier is all about efficiency, choosing your own optimal point once you're there is subject to your risk tolerance.