Are You Diversified?
By Clay Baker & Mikael Rudolfsen - Crystal Waters Capital September 2019
Diversify (1). Every investor has heard the siren call to get diversified. “Diversification protects. Diversification spreads risk. Diversification opens you up to more opportunities as market rotations take place.”
While many investors conceptually understand the need for diversification, many, if not most, are unintentionally overweight certain areas. Concentration of assets in a few areas such as owning too much real-estate or having only high-tech, high-growth stocks creates potential for periodic large gains, but also adds tremendous risk for disproportionate losses, from which investors take years to recover. Only after the fact does it become clear to people that they should have been better diversified.
"Hindsight is the cruelest university to attend. The charge for the education is double what it was worth, while foresight was offered for free" - Clay Baker
Indeed, diversification is essential for successful investing, but there is a trade-off and a balance to consider. You obviously must be diversified enough to get through tough economic times or unexpected bad luck in order to minimize periods of losses, but you also need to make sure you don’t diversify away any chance of material capital returns. Investors who are too diversified or overly cautious can end up with below-average returns. Over an extended period of time, this will materially begin to affect their future financial wealth and it is time and opportunity they will never get back.
In this paper we will discuss ways investors typically are too heavily invested in particular areas, and how to best diversify without losing opportunities to continue growing their wealth.
Are You Over-invested?
While most investors recognize the importance of diversification, many treat diversification without thinking from a total portfolio perspective. In other words, they segregate and treat their investments as if they were totally separate, diversifying each (floor of their investment house) as if the others didn’t exist. This is sometimes referred to as mental accounting.
For example, people may refer to their portfolio when referring to their investments in financial assets. Such investors tend to think of other assets, such as their home, certificates of deposit, and other real-estate investments as totally separate, when in fact they are an integral part. By not managing their portfolio of assets from an overall risk and return perspective, investors often leave themselves vulnerable to making poor decisions about individual portions of their portfolio.
Having too high of a concentration of any asset can be a threat to an individual's financial future, and investors should always be adjusting and re-balancing. Being overweight by 50 shares of Clorox in your stock portfolio is easy to fix; sell the 50 shares and either hold the cash or reinvest that money into another stock that offers growth but counterbalances the risk. However being overweight in other areas often requires a bit more effort to correct, and waiting to do so represents a significant risk. Time is the most valuable asset any of us have, you can’t make it or buy it, so there's an urgency to getting this work done; to avoid risks and to get those assets producing in new ways.
"It's the only thing you can't buy. I mean, I can buy anything I want, basically, but I can't buy time". - Warren Buffett (2)
Being over-invested in particular areas can manifest itself in several ways. Owning too much real estate in addition to your primary home is a common example, but so is owning too many stocks in a single highly volatile sector, owning individual shares of your own company stock, owning stock options that vest and are converted to stock, or a 401(K) or other retirement plan that has grown over the years to become a primary, but disproportionately large asset for your retirement. All of these represent excessive exposure to a single asset or collection of homogeneous assets that creates risk that far exceeds the expected return. While it’s a great show of support to own shares in the company where you work, nobody expects you to keep all your eggs in one basket. It’s great that your retirement fund has grown substantially over the years, but if you take a closer look, it is likely a substantial part of your wealth that is now tied to a single basket of financial assets that often is too risky or too conservative.
Over-investing in your company or employer
Employees across the U.S. have had to learn this lesson the hard way. Recent examples include Enron(3), Lehman Brothers(4) and Bear Stearns(5) - all companies that collapsed even though they were run by smart people and seemed too big to fail. Employees at these big companies lost not only their jobs, but also a substantial portion of their investments and savings. These collapses that have been well-documented in the media, but there are lots of other examples that are far less prominent, but where the effects of employees holding too much of a company’s stock has experienced a more gradual, yet significant loss of accumulated savings which has been devastating for their financial future.
General Electric Co. was one of the first companies to be placed in the Dow Jones Industrial Average 112 years ago, and the company has a long history of executives and employees all being significant owners of GE stock through stock option compensation as well as the company-sponsored 401(K). As recent as 2016, GE stock still represented more than one-third of the company’s 401(K). In October 2007 GE stock reached just over $40 per share, and the strategy of holding that much GE stock was paying off. However, times change, and today in 2019 the stock is trading at just over $9 - a decline of over 77%. If GE employees were relying on the company’s shares to fund retirement, medical expenses, college educations, or a child’s wedding, they instead saw years of work and savings wiped out due to having too much invested in a single asset through the company where they work. To their credit, GE has a highly diversified set of 401(K) holdings that was meant to offset the high concentration of GE common stock. However, the over-diversification may additionally have hurt long term performance by being too diversified and diluting much of the growth away, another risk that many investors don’t readily consider.
Scores of other businesses, small and large, can be included in the list alongside GE of companies that have experienced a significant decline. However, just because a business experiences a downfall, doesn’t mean that individuals who work there have to experience the same tragedy; there are strategies, available to most people, to reallocate and diversify, protect and continuously grow asset values.
Over-investing in retirement accounts
As counter-intuitive as it may sound, you can be invested too much in retirement accounts. To start, many 401(K) accounts are conservatively structured from a perspective of “do no harm, growing below average and literally costing you money each year.
Additionally, you will eventually need to pay taxes on the payout and no one can predict future tax rates, so investors should always consider other ways to defer taxes in retirement in addition to just focusing on deferring prior to retirement. Also, with a 401(K), you will be forced to take a required minimum distribution at 70-1/2 even if you don’t need the funds. Finally, if you are thinking ahead to estate planning, you need to consider that everything you own gets a step-up in tax basis when you pass away (a benefit that makes your heirs pay less taxes). However, 401(k) and traditional IRAs do not. If retirement plans are funded with pre-tax dollars, they are 100% taxable to your heirs once they start tapping into the funds.
Retirement accounts are a great tool and a necessity for everyone, but should still be treated as only one of many components of a broader portfolio. Investors would do well to understand the diversification within their retirement account, and possibly consider using self-directed IRAs and 401(K), which allows you to broaden the scope of assets, reduce the concentration of risk, and possibly improving overall returns.
Strategies for Diversification
The challenge when diversifying is to avoid the pitfall of over-diversification or as Peter Lynch coined the term, Diworsification(6). This is diversifying to the point where the returns are no longer compensating for the risk taken and each individual holding is not contributing to either the growth or decline of the portfolio. In his seminal investment book The Intelligent Investor (1949), Benjamin Graham suggests that owning between 10 and 30 different companies will adequately diversify a stock portfolio. In contrast, a 2003 study done by Meir Statman titled "How Much Diversification is Enough?" stated, "today's optimal level of diversification, measured by the rules of mean-variance portfolio theory, exceeds 300 stocks." Most investors wouldn’t be able to sort this out, so a professional with a strict discipline is probably in order.
Keeping Peter Lynch in mind, there are several strategies that any individual can use to protect themselves from being overexposed to a single asset.
Diversify your existing stocks
Diversify with passive investing in index funds
Diversify into real estate and other real property
Diversify into stocks with an active manager
Diversify your existing stocks
Lots of people who invest personally, invest in companies or areas that they know well. As a result, an existing portfolio of stocks and bonds may have a high concentration of similar stocks , and may not be adequately diversified to provide the right balance between growth and protecting capital. Just because a portfolio has 20-30 stocks doesn’t mean that its actually diversified, or that the stocks chosen are the best choices for an individual investors objectives. For example, an investor with a portfolio that is mostly invested in Facebook, Amazon, Netflix, Google (FANG) and Apple (FAANG) may think they have the growth part figured out and because these are all fundamentally different businesses, it looks diversified. Certainly if you’ve owned these stocks together over the last decade you’ve done well in terms of growth. But you need to remember that we’ve been in a 10-year bull market with continual economic expansion, which is longer than usual and not a permanent state. What happens when technology stocks no longer lead the market, the economy slows, or government regulation steps in and changes the economic futures of these companies? Other stocks are likely to lead in the future, and what is important to keep in mind is that FAANGs weren’t even the market leaders during our 10-year bull market, as seen in figure 1. below. From a return perspective, since March 2009 to August 2018, only Netflix and Amazon are in the top 15 on a cumulative basis with many other companies being far better investments.(7)
To surface these companies ahead of time, an investor would need specialized help and a diversified strategy that focuses on companies with growing revenue and earnings and fundamentally sound balance sheets.
Another key point to understand about FANG stocks is that they are highly correlated, meaning they trade similar to each other, and are not diversified at all. We might say that those that live by the FANG, die by the FANG. In fact, those stocks mirror the broader market fairly closely. As seen in Table 1 below, the daily return correlation for the FANG stocks, the Technology Select Sector SPDR Fund (NYSE: XLK) and the SPDR S&P 500 ETF Trust (NYSE: SPY) shows a relatively high level of correlation in daily returns among the group dating all the way back to the beginning of 2012. In a diversified portfolio, you want the opposite. You want companies that do not move in lockstep with the broader market or each other.
To make the necessary adjustments to fix this diversification problem, an individual investor would need to develop a model that identifies each holdings value and percentage weight in the portfolio along with its Beta score and correlation to every other stock in the portfolio. They would then have to research each stock’s growth and return potential to finally identify a collection of stocks that will offer acceptable return while also being less correlated to each other and also have varying degrees of correlation to the overall market. To this right, it usually ends up being a lot of work, both initially and ongoing, but the end-result is usually worth the effort with an optimal balance of growth and risk.
For comparison, let’s just look at the current year (2019). Table 2 on the following page shows the best performing stocks, by share price year-to-date and individual correlation as of September 2019.. An investor looking to properly diversify while also growing their net worth would likely need to have selected at least a handful of the names on this list that collectively provide a diversified portfolio.
Chipotle Mexican Grill tops the list and would have been a great investment. However, the food scare at their restaurants is as fresh as their ingredients. Would this likely have made it onto your buy list? MarketAxess Holdings isn’t exactly a household name. Would this one have even surfaced as an option? A manufacturing company that uses a lot of steel and aluminum doesn’t sound popular during our trade wars with China, but Ball Corp would have given you a nearly 75% return with terrific risk reduction. According to the media, retail is dead since everyone shops online, and even that is supposedly at risk with the pending yield curve and a pending recession (not so!). However, consumer spending remains healthy and strong, and Target Corp. gave you a nearly 62% return plus a nice dividend. Ever heard of Copart, Inc? Likely you haven’t, but if you have ever bought a used car from a lot or auction house, Copart played a significant role behind the scenes. While the financial media keeps pumping the story about ‘peak autos’ and declining auto sales, the used car market chugs along and companies like CoPart, O’Reilys and AutoZone carve out a profitable niche where investors benefit.
Every name on the list presents challenges to an investor’s thinking despite the benefits of great returns and diversification each offers. Identifying great returns in advance and assembling and managing the right combination of companies that simultaneously provide adequate diversification for expected returns can absolutely be done. However, it requires significant effort and expertise, and is best done by financial professionals or knowledgeable investors who have the experience, tools and consistent attention to the details.
Diversify with passive investing in index funds
The ultimate diversification, for someone who is willing to accept average returns is to buy an index fund and forget about it, knowing they are now widely diversified.
Index funds make it easy to own an investment that will track a large group of companies without actually owning any of the individual stocks. There are too many index funds to cover in any detail here, and for the purpose of this research we simply want to look at the pros and cons of an index fund as a diversification tool.
Generally an index fund is a good way to diversify without having to do any work to determine which stocks to select and in which quantities so that your portfolio is properly weighted. The returns, however, will vary dramatically from year-to-year with market fluctuations, and the per share value can be volatile on a day-to-day basis; sometimes more than an investor can handle. Investors should know that while this seems like an easy and cheap way to get diversified, there’s no free lunch. Index fund performance looks terrific in a sustained bull market, but in a pull-back or a full blown recession, and index funds performance can be downright scary and unmanageable for many.
While Index funds do provide value and may work for some, astute investors know that this type of passive investing comes with its own set of risks. Warren Buffett famously commented on diversification through index funds, saying:
"Wide diversification is only required when investors do not understand what they are doing". - Warren Buffett
The founder of Investor's Business Daily added on the same topic that:
“Over-diversification is a hedge for ignorance.” - William O’Neil
What Buffett and O’Neil are both saying is that investors know they need to invest, but don’t know enough to actually do it, so they feel safer letting someone else buy large basket of stocks that is statistically likely to have enough winners to offset the losers. Fair enough, but hardly a ringing endorsement for passive investing.
Bond expert and CEO of Doubleline Capital, Jeffrey Gundlach, recently added his concern.
“I’m not at all a fan of passive investing. In fact, I think passive investing ... has reached mania status as we went into the peak of the global stock market…I think in fact that passive investing and robo-advisors ...are going to exacerbate problems in the market because it’s herding behavior” - Jeffrey Gundlach Doubleline Capital CEO (8)
Looking at Table 3 below we can see the annual 10-year history of the Standard & Poor 500 ETF (SPY), the largest S&P 500 index by NET Asset Value.
When the DOT COM bubble burst and we entered the recession of 2000, investors in the Standard & Poor 500 ETF (SPY) saw their investment take a -9.15% hit in 2000 alone. Not bad. Most investors can withstand a 10% decline, and many will invest more to average down. But when the SPY declined again -11.86% in 2001, the panic began. This was followed by the -22.12% decline in 2002; where only the strongest of long term investors were willing to stay invested. A $10,000 investment in the SPY in 2000 was worth $6,236 at the end of 2002. It would take investors until 2006 to get back to their 2000 levels , only to see the Standard & Poor ETF collapse -36.97% in 2008, almost taking them back again to 2002 levels. When an investor suffers repeated losses like this, the biggest hurdle to overcome, aside from confusion, is the time and growth required to overcome the losses and just get back to even. There’s a formula for calculating this:
y = x/(1-x)
where y is the percentage gain required to break even and x is the percentage lost.
So if you lost 80% (.80), the break-even recovery gain is .8/(1-.8)=4, or 400%.
Table 4 illustrates that a 50% loss in a stock will require a 100% gain just to get back to even.
Loss (%)....... Req'd Gain
Average market returns can be a roller coaster ride with lots of systemic risk that only gets worse the closer you track the market. After 2008, many investors simply threw in the towel. They simply couldn’t envision anything other than further declines, causing them to miss out on one of the longest periods of sustained growth and wealth creation.
“The market pendulum always swings too far in both directions. If you tie yourself to the pendulum, be prepared for one heck of a ride” - Mikael Rudolfsen
Alternatively, index funds can also be slow going with many years of single digit returns. While the long term returns from many index funds are favorable, investors must be willing to endure periods of significant volatility as well as slow growth, and know when to buy more shares in these down periods. In reality, most investors aren’t able to stay invested and weather the tough times. Instead they go in and out of the market, significantly diminishing returns; hardly anyone actually gets those average returns from an index fund.
Passive investing through Index funds have a place in an investor’s overall diversification plan, but it should not be the sole method of financial growth and diversification; primarily because there are other ways to offset large market draw-downs, create higher-than-average returns, and mitigate shorter term fluctuations that can often cause an investor to pull out of the market and miss the long term averages.
Diversify into Real-Estate and Other Real Property
The third method of diversification is in fact one of the most common. If you own a home you’ve already used this strategy. If you own a primary home and an income property or a vacation property you’ve taken this strategy to the next level, and if you are invested in REITS (Real-Estate Investment Trusts), you are deeply invested and should carefully consider how much of your network is possibly over-allocated to real estate. Real estate has actually had a fairly uncorrelated return stream with U.S. stocks since 2009.
As seen in figure 2 below, the annual returns for the Vanguard REIT ETF (VNQ) vary widely when compared to the annual returns for the S&P 500 ETF (SPY) every year since 2009. Real-estate has under-performed the stock market over the past 3 years, but has provided investors far superior returns in the two years prior. This again points to the need for diversification.
Correlations are far from constant in the markets so it makes sense to look at how these relationships can evolve over time when comparing asset classes. Figure 3 shows the correlation between the S&P 500 and the Dow Jones REIT Index going back to 1978. It’s clear that real-estate does provide effective diversification, but similar to index funds, investors need to understand likely returns so to not diversify growth out of their portfolio.
Other forms of diversification in real property include collectible art, car and motorcycle collections, rare coins, sports memorabilia, or direct investing in a business other than your own where there are real assets such as land, buildings and equipment. Investing in your best friends new pizza franchise or starting a car collection may be an excellent investment, but it may also come with a number of risks. What if your friends pizza franchise has a fire and the revenue you expected stops coming in until the store is repaired? What if your friend and his wife are partners in the restaurant and they decide to get divorced; is it still the same investment for you? Again, each diversification tactic always comes with its own set of investment and liquidity risks that should be accounted for.
Collector cars have had remarkable appreciation since 2007, but the only investors who participated in the growth owned very specific cars in certain classifications. The Hagerty Valuation Index for Affordable Classics has been the out-performer (see figure 4 below), but has in many ways not offered any diversification. Since 2007 the cars in this index have increased in value roughly 52% overall, much in line with the stock market. The indexes for Ferrari’s, muscle cars, as well as British and German collectibles have also seen periods of growth, but also steep declines, with far less correlation to the stock market.
Unlike many other investments, collectibles come with a benefit that can’t be quantified; you can actively enjoy them. Whether its art, cars, motorcycles or any other collectible, they all have an element of joy that comes from being able to use them, see them everyday, share them with others and go to events where other collectors gather.
The challenge with this type of asset is finding a buyer when you decide you need the cash for something else. Usually buyers are found at auction, where the ultimate value is determined by the market. Unlike stocks, collector cars are not nearly as liquid. For those investors who know the market for real estate and collectibles this can be a good diversifier for a portion of an individual's net worth. Just like an index fund has an expense ratio, collectibles also come with other costs; like insurance, storage, maintenance and security. Every investment has costs, knowing them and keeping them low is critical to long term performance and wise diversification.
Diversify into Stocks with an Active Manager
The final category for an investor to consider is an actively managed portfolio of stocks, bonds, options and other highly liquid assets that can be readily traded on the major stock exchanges. Active management simply means that you have an adviser who is making decisions about what to invest in on your behalf, or on behalf of a fund where you participate as a co-owner of a shared portfolio. Advisers come in several forms offering investors needing diversification a broad array of choices.
Registered Investment Advisor (RIA)
An RIA is a person or firm who helps companies and private individuals allocate capital for investment purposes. Which regulators any particular adviser is registered with depends mostly on the value of the assets they manage, along with whether they advise corporate or individual clients. In general, advisors who have at least $25 million in assets under management or provide advice to investment companies are required to register with the SEC. Advisors managing smaller amounts typically register with state securities authorities. Registering as an RIA isn't meant to denote any form of recommendation or endorsement by the SEC or state securities regulators. It means only that the investment advisor has fulfilled all the requirements for registration. In an age when the traditional stock broker is all but gone, brokerage firms and independent firms are hiring RIA’s as fiduciaries and client advisers. Typically an RIA charges a 1% fee for assets under management (AUM). Some may charge less for managing large sums of money, say over $1 million dollars. An RIA will often be able to offer up a plan that provides diversification, but their ability to provide unique ideas that can outperform the market aren’t readily available. One trend investors must consider are the number of RIAs selling their business to private equity firms.(9) Private equity firms have found that RIAs represent a value to their business that is a lot like an insurance company, your investments are a steady, reliable source of revenues from ongoing fees.
In a recent study, TD Ameritrade set out to learn why some RIA’s outperformed their peers and what they learned had little to do with how well their clients portfolios performed. The best performing RIA’s had done more acquisitions of other firms and in the process acquired more people who can continually bring in more business.(10)
This is one of many titles that have no legal or regulatory meaning, though the representative may in fact hold some licenses and other educational credentials. These include: Financial Advisor, Financial Consultant, Financial Planner, and a variety of other titles that describe someone who wants to manage your money. Wealth Managers are often Registered Investment Advisors (RIA), stock brokers, insurance agents, Accountants and CPA’s. An RIA follows the fiduciary standard and is required to register with the SEC or their state depending on what types of investment products they sell or advise clients to buy and how much money they manage.
Wealth management is more than just investment advice, and often includes services for all parts of a person's financial life. Rather than trying to integrate advice from a series of professionals, clients benefit from a holistic approach in which a single manager coordinates all the services needed to manage their money and plan for their own or their family's current and future needs. An RIA or Wealth Manager may in fact be an insurance agent and be able to advise exceptionally well on insurance needs. Depending on the firm, a wealth manager may provide a vast array of financial services, while at others the services are strictly limited to investment advice. Major brokerage firms like Morgan Stanley, JPMorgan Chase, Schwab, Edward Jones and others all have wealth management divisions where advisers work like a small firm within the larger parent firm. Often the products they provide to clients are known as ‘managed accounts’. A managed account isn’t really run by your adviser. The adviser spends time learning about your specific needs and then a portfolio manager somewhere in the firm does the buying and selling to meet the objectives you established with your adviser. “I need income”, expect a lot of stocks and bonds that pay dividends. “I need growth”, expect a portfolio filled with high Beta growth stocks. “I need to protect my assets and not take any risks”, expect a portfolio filled with bond funds or target date funds. A managed account portfolio can be very active, sometimes including several trades a day, depending on what the manager thinks is required for your account. Don’t expect a call to see if you’re okay with the buys - it just happens.
Alternative Investments - Private Equity & Hedge Funds
One of the most lucrative strategies for the investor looking to diversify while maintaining growth is alternative investments. Sometimes called private equity, hedge funds or alternative asset management, depending on their investment style, these investment vehicles are tailor-made for a specific purpose.
Private equity is usually interested in acquiring a controlling interest in a non-public company or a large enough position to get their people installed on the board of directors. Hedge funds, in contrast, are typically interested in the stocks of public companies that meet their specific investment strategy. There are funds just for diversified growth, crypto-currencies, growth stocks, option funds, currency trading, long only strategies, long and short, short only strategies, and long biased funds. Investors can pick from a variety of funds with different growth and risk profiles in order to get the optimal diversification for their overall portfolio.
These investment firms are regulated by a host of securities agencies (SEC, FINRA, etc.) but because of the way they are regulated, and the fact that only accredited investors are allowed to invest, the management of these firms have greater latitude to seek higher returns where the investors return is a greater priority than generating fees. The primary way these firms go after higher returns is by developing a unique investment strategy, testing it over a long period of time and then opening the strategy to investors who have enough experience and resources to participate in a pooled investment. This is probably the biggest difference between the personal investment adviser who is managing your individual account and an alternative investment fund where the investor becomes a limited partner in a portfolio that’s professionally managed.
The most common structure for these investment funds is a limited partnership where investors are owners of the fund, and the portfolio managers are hired by the limited partnership to make the investment decisions. Fees for these firms are typically arranged so that the limited partners pay the managers a percentage fee to cover the managers costs of doing business plus a percentage bonus for exceeding the funds benchmark. Fees will vary, but a fund may have a 2 and 20 fee structure where the annual fee to the partnership is 2% of assets under management billed quarterly (.5% per quarter). If the fund exceeds it benchmark, say the S&P 500, the managers earn a performance bonus of 20% of the amount over the benchmark. There is a range of fees among these firms with some smaller firms offering lower fees. Typically there is no bonus for a negative return that outperforms the benchmarks greater negative return.
Size can be an advantage in this space, in that smaller can be better. With a smaller firm the investor can usually count on getting better service. While the fund has no real obligation to communicate with limited partners, the better firms will always be open to talking with their investors at anytime. The primary advantage of a smaller firm is their ability to invest in smaller companies where significant growth can be achieved. Warren Buffett has lamented that he could generate 50% returns if only he had less money to invest. That's because it's the smaller, faster growing companies that typically offer the highest returns. Buffett can’t invest in small companies because even with a 50% return, those tiny companies wouldn’t have any meaningful impact on Berkshire Hathaway’s returns. However, a smaller hedge fund can buy these companies everyday and generate very meaningful returns, at least until the firm and its portfolio becomes too large to invest in small caps.
Typically there is a strict discipline for the fund around the type of stocks it buys, how long investments are held, how risk is managed and how long an investor is required to remain a member of the fund. Known as the ‘Lock-up period’, a fund may require investors to remain in the fund contractually for 1 to 5 years. The value of this to the fund is stability, but the value to the investor is that they don’t jump in and out of the market. Investors stay invested, providing the fund managers with the time required to see their long term investment thesis materialize.
Alternative investment funds or hedge funds can often provide an investor important diversification not available elsewhere. But not all funds are created equal. They have different strategies and tax implications, and while there are clear benefits, investors should make sure they understand their full portfolio and select the right type of fund for optimal diversification and growth. The spectrum of funds range from long-term buy-and-hold to daily trading. For most investors seeking diversification through hedge funds, a long or long-biased U.S. equities fund makes the most sense since this is the most liquid and stable market, providing fund managers the most options to execute on the stated strategy. Long term or long biased funds typically also provide better tax efficiency than those that are focused on short term trading, holding investments long enough to take advantage of the lower long term capital gains rate. (11)
Investments in hedge funds is growing, particularly from the leading edge of investing, the institutional investor managing pensions. According to Pensions & Investments,(12)
During the six months ended June 30, new investment in hedge funds…as well as top-up allocations to existing funds as reported by Pensions & Investments totaled $6 billion, were up 17.8% over the same period a year earlier. - Pensions&Investment August 5, 2019
What’s driving the increase of funds into hedge funds is a desire to diversify holdings. While some institutional investors are increasing the amount of money allocated to hedge funds, others are increasing the number of hedge funds they invest in or the number of managers they employ, all in an effort to diversify.
Whether you do it alone or work with a financial professional, diversification is an important component of your investment strategy, and the goal should always be to include new assets to your portfolio that provide opportunities for growth while reducing the overall risk of the portfolio. The value of individual stocks, bonds, index funds, hedge funds, real-estate, or other real property investments, is that each asset’s value behave differently in isolation versus in combination to one another. As an investor, this offers you an opportunity to combine assets in such a way that gives you both growth and diversification, and essentially increases your return per unit of risk taken.
Diversification is not without risk, though, and there is a very real opportunity cost. Through diversification, if you are not careful, you can dilute away growth and valuable capital appreciation that you might never get back. Capital appreciation (growth) and diversification (risk mitigation) is not an either/or option and should always go hand-in-hand, and if you are thoughtful in your approach, there are lots of exciting opportunities to increase your wealth without taking great risk.