Diversification’s Role as a Risk-Reduction Tool
Richard Bernstein is the chief executive officer of Richard Bernstein Advisors LLC. We spoke recently about diversification and asset allocation.
Charles Rotblut (CR): You sub-advise a mutual fund that can vary widely in terms of its allocation to bonds and stocks. How do you determine what the right asset allocation is?
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Richard Bernstein (BR): There are two mutual funds we run. Eaton Vance Richard Bernstein Equity Strategy fund (ERBAX) is a global equities fund, and we have great latitude in that we can go anywhere around the world. Eaton Vance Richard Bernstein All Asset Strategy fund (EARAX) is probably the one you are referring to: It is a global, go anywhere, all-asset fund.
How do we set the asset allocation? Well, I was at Merrill Lynch for over 20 years and one of the things we used to talk a lot about at Merrill was that people never understood diversification. They see charts and they are told that if they diversify their portfolio, they will get less risk and higher returns. What we always used to tell people is that diversification is not a return-enhancement tool; it is a risk-reduction tool. If you happen to get higher returns, then that’s gravy; that’s the icing on the cake. But really what diversification is all about is reducing the volatility of your portfolio. So that’s one thing.
Number two is if that’s the goal, then how do you reduce the volatility of your portfolio? Well, you have to look at the correlation among the asset classes. And it’s not the number of asset classes that determines the diversification; it’s the correlation among those asset classes that determines diversification [Figure 1]. Somebody right now could say, well, I have U.S. stocks, non-U.S. stocks, corporate bonds, high-yield bonds, non-U.S. bonds, commodities, gold, private equity and hedge funds, but there is no diversification in the portfolio because those asset classes named are very highly correlated. So it’s not the number of asset classes. You could technically form a very well-diversified portfolio with just two asset classes if their correlations are negative.
What we like to do is to think of diversification as a seesaw. Some assets go up and some assets go down; the fulcrum of the seesaw is the volatility of your portfolio. So you have to try to figure out which side of the seesaw your assets are on. For a long time, you could actually balance out a portfolio by kind of an even number of asset classes. The problem today—and for the last five or six years—is that the seesaw has become very skewed. It is completely imbalanced. What is happening is that the correlation of all of these asset classes is going up. Really, the only asset class sitting on the other side of the seesaw is basically the Treasuries. What we do is try to find out the correlations in all of these different asset classes, how much risk and how we want to tilt that seesaw. That’s kind of what we are doing.
The final point is: How do you measure the correlation? Honestly, you can make correlation say anything you want, depending on the time period you use. “I want to use daily data for three weeks,” or “I want to use monthly data for five years.” Basically you can make correlation say anything you want. If you are a commodity manager, you can show that commodities are negatively correlated—all you have to do is find the right time period. We look at what we call structural correlations. Structural correlations are the long-term trend in the correlation. So we are not looking at all the ups and downs. It’s literally like watching paint dry. We can measure true underlying longer-term correlations, and they don’t change very frequently. That’s what we use and that’s how seven years ago we began to notice that the seesaw was becoming very unstable. And I think people have learned that it has become very hard to diversify portfolios. That’ll change, obviously. As those correlations change, we will change our portfolio.
Richard Bernstein is the chief executive officer of Richard Bernstein Advisors LLC.