Diversification Benefits, Where Art Thou?

Abstract

Following the global financial crisis, a portfolio concentrated in US large cap equity and aggregate fixed income has provided higher returns than diversified portfolios through 2019. Such a prolonged experience causes investors to question the benefits of diversification. This leads us to use a longer history of data across 15 asset classes to understand the historical benefits of diversifying a portfolio with international equity, real assets, and below-investment-grade fixed income. The authors’ results portray the frequency and magnitude of risk-adjusted return improvement coming from different diversifying asset classes over five-year holding periods. The authors find that certain asset classes, such as below-investment-grade fixed income, regularly improve risk-adjusted return of the portfolio, while other asset classes like commodities improve risk-adjusted returns less frequently. Further, they observe that some asset classes do not deliver meaningful risk-adjusted return improvements in the presence of other asset classes. Their conclusion is that investors should continue to build diversified portfolios, but in doing so they should consider that some asset classes more consistently improved risk-adjusted returns than others.

TOPICS: Wealth management, retirement, portfolio construction

Key Findings

• • Certain asset classes, such as below-investment-grade fixed income, have provided consistent diversification benefits through time, while other asset classes, such as commodities (despite its low correlation to other asset classes), have less frequently improved portfolio performance.

• • Some asset classes have not delivered meaningful portfolio diversification benefits in the presence of other asset classes during the periods we examined.

• • We observe cyclicality in the improvement of portfolio returns from holding a more diversified portfolio. The periodicity appears longer than the US business cycle. Moreover, the time series of relative price-to-earnings ratios of US and international equity appears to move countercyclically with the outperformance of diversified portfolios.