diversification only needs equities debt and cash

Research across thousands of institutional portfolios shows diversification producing higher returns and lower volatility needs simpler not more complex asset allocation.

diversification only needs equities debt and cash


Looking at institutional portfolios for the ten-year period from January 2000 to September 2010, diversification across the asset classes has developed away from equities and bonds but volatility has remained virtually the same.

A 60:40 equities:bond allocation for the decade shows an annualized return of 3.7%, volatility of 11% and a maximum drawdown of -27.8%.

A portfolio investing 40% in equities, 30% fixed income, 8% private equity, 8% real estate, 7% commodities and 7% hedge funds would have given investors slightly higher returns (5.2%), with a higher drawdown (-30.8% maximum) with a volatility of a comparable 10.6%.

Khaled Said, joint chief investment officer at Capital Generation Partners, attributes this to a fundamental misunderstanding of how asset classes perform and the correlations between them.

“The problem is that investors have been trying to diversify by investing into asset classes that fundamentally behave in similar ways. What people thought of as ’alternatives’ such as private equity and real estate are in fact just another way of investing in equity,” he added.

“Far from diversifying portfolios, they only served to concentrate portfolios. So when the 2008 crisis hit, the damage to portfolios was exacerbated by the very asset classes that were supposed to be diversifiers. Investors need to go back to first principles to work out how to create truly robust portfolios through diversification.”

He then put forward the Capital Generation Partners’ approach to portfolio diversification using only three asset classes – equity, debt and cash – and within that, four strategy options: discretionary, systematic, directional and arbitrage.

Said argues one implication is that hedge funds should not be viewed as an asset class in themselves, concluding: “Investors wanting to protect their portfolios through true diversification should discard the traditional asset class buckets of fixed income, cash, public equity, private equity, hedge funds and real assets in favour of a simpler but more powerful classification.”


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