True Diversification is Hard to Achieve

Apr 14 2009 | 8:51am ET

By Matthew Tuttle -- We often hear that investors need to have diversified portfolios to protect against market volatility. However, as many investors found out during the bear markets of 2000-2002 and 2007-2008, a traditionally-diversified portfolio doesn’t provide much downside protection when the market crashes and takes everything down with it.

Matthew TuttleMatthew TuttleTraditional Diversification

The traditional theory of diversification comes from modern portfolio theory. The idea is that if investors add non-correlated assets to their portfolio, they can increase returns and lower risk. While this is true in theory, in practice it is very hard to achieve. When most investors think about a diversified portfolio they think about large stocks, medium-sized stocks, small stocks, international stocks and bonds. A more advanced investor might also have allocations to hedge funds and private equity.

The problem with this approach is that during a market crisis most of these types of assets tend to fall at the same time. Diversification will give you some protection, as assets like bonds probably won’t decline to the same extent as stocks, but how much comfort it is when the market is down 40% and your portfolio is only down 30%?

One of the main reasons that diversification does not provide a high level of protection is that, even though an investor might be giving money to managers who buy different types of stocks, the managers are still looking at the market in the same way. Whether a money manager buys large stocks, small stocks, medium-sized stocks, growth stocks, value stocks or international stocks, they are all looking for the same thing—stocks that are undervalued and poised to go up. In a down market there are an abundance of undervalued stocks, but they can stay undervalued for a long time.

The other big problem with traditional diversification is that there is no way for a diversified portfolio to make money in a steep market decline. When stocks are going down the best an investor can hope for is to not be down as much as the market.

Another Way to Look at Diversification

A different way to look at diversification is to be diversified by the methodology used to select which in which markets to invest. For example, our portfolios currently consist of four models: one for the Standard & Poor’s 500 Index, one for the NASDAQ, one for energy stocks and one for 30-year Treasury Bonds. Our models contain an absolute return component, as the S&P 500, NASDAQ and 30-year Treasury Bond systems can go long or short, allowing them to make money in an any environment.

The models are also completely different from each other in what they look for to decide whether to be long the market, short the market, or in cash. For example, during much of November our S&P 500 model was long while our NASDAQ model was short. We use trend following models and models that look for divergence.

Trend-Following

At any point in time a market can be doing one of three things—trending up, trending down or going sideways. A trend-following approach seeks to profit from up trends and down trends. For example, in the beginning of 2008 commodities and the euro were in strong uptrends. Over the summer, these trends reversed. Investors who used a trend-following approach could have played these trends up and down.

Divergence

Many markets move in tandem; a move in one market can be predictive of moves in another market. For example, this year, when the U.S. dollar has gone up, oil has tended to go down. Trading divergences involves finding these markets that are predictive and then entering trades when they diverge.

For example, let’s assume that Coca-Cola and Pepsi tend to move together and because Coke is bigger, moves in its stock tend to predict moves in Pepsi stock. You could watch this relationship and buy Pepsi when Coke goes up but Pepsi doesn’t.

Because we use different types of models there are times when our S&P 500 system might be long and our NASDAQ system might be short (or the other way around). Because each of our models uses different indicators and a different methodology they are not correlated with each other, allowing us to obtain true diversification.

Matthew Tuttle is president of Tuttle Wealth Management, which specializes in designing innovative absolute return investment strategies.


In Depth

Q&A: Brevan Howard’s Charlotte Valeur Talks Strategy

Sep 18 2014 | 11:18am ET

Charlotte Valeur chairs the board of Brevan Howard Credit Catalysts, an LSE listed...

Lifestyle

Hedgies Rock Out For Children's Charity

Sep 15 2014 | 8:40am ET

It's that time of year again—when hedgies trade in their spreadsheets for guitars...

Guest Contributor

Volkered: How Financial Sector Reforms are Creating Opportunities for Hedge Funds

Sep 16 2014 | 11:28am ET

New regulations have dramatically curtailed proprietary trading activity in investment...

 

Editor's Note

    Get A Sneak Peak Of The Alpha Pages

    Aug 25 2014 | 11:21am ET

    As many of you know, FINalternatives was recently acquired by the owners of Futures magazine, a firm called The Alpha Pages LLC. Today marks the soft-launch of a new sister site for both publications. As its name suggests, The Alpha Pages will cover all types of alternative investments, going far beyond the more well-known ones such as hedge funds and private equity. Read more…

 

Futures Magazine

September 2014 Cover

The London Whale: Rogue risk management

Credit default swaps brought down the London Whale and cost JPMorgan $6.2 billion. Here is how it happened.

The Alpha Pages

TAP July/August 2014 Cover

The Alpha Pages Interview: Senator Rand Paul

Senator Paul sat down in the debut series of the Alpha Pages Interview to discuss the broken tax code, regulation surrounding Bitcoin, and his plans for the 2016 Presidential election.