Managing Diversification and Drawdowns in the “New Normal”

Michael Salerno, President
William McGirr, Managing Director
AUA Capital Management

February 2015

It is easy to lose sight of broader market shifts while a constant stream of often-conflicting information barrages us daily. This may be even more relevant for a US based investor experiencing the returns and movements of the S&P 500 over the past 5 years. Since the end of the 2008-2009 crash the US market has moved up relentlessly, with each pause small, benign and over quickly. Before the memory of the crash, or even a much more common 20% correction, recedes completely, it may be helpful to recall that in 2008-2009 diversification alone failed to provide adequate risk management for an investor’s portfolio. Going forward this may also be true for most substantive market down turns.

Traditional diversification is based on dispersion among asset classes and geographies. Traditional asset classes include equities, bonds, commodities and currencies, with the bulk of capital being allocated to equities and bonds, and smaller slices to commodities and currencies. The correlations among these asset classes have been rising and with increased globalization and interdependency of markets geographic diversification is fading. Even investment strategies touted as new asset classes and frequently housed in hedge fund structures may provide limited diversification benefits. Jan Straatman discusses this in his paper “Innovations in Asset Allocation and Risk Management after the Crisis”, CFA Institute, March 2013, and notes that “increasing the number of asset classes in a portfolio does not always increase effective diversification because many of the so-called new asset classes have the same types of risks and exposures as traditional asset classes.” This is especially true in tail risk scenarios as Jan also notes “investors can no longer depend on the correlations of traditional asset classes to provide diversification when it is needed most because correlations during tail events differs from normal correlation.”

While equity returns during the recent past have been inconsistent, over the last 25 to 30 years, a traditional passive 60/40 portfolio (60% equity exposure, 40% fixed income exposure) has benefited significantly from an extended bond bull market. Over the long-term, starting valuations have a substantive impact on future returns and the valuations of both the US bond and equity markets are currently well above their historical averages – based on metrics such as current bond yields and CAPE (cyclically adjusted price earnings) ratios. This poses a serious challenge for investors who require a certain return level and suggests that traditional methods of asset allocation and investment management may not be able to produce their historical long-term results.

The weakness of available diversification options along with high current valuation levels subjects portfolios to the risk of large drawdowns. These drawdowns can severely impact wealth accumulation, particularly in portfolios called upon to make episodic distributions such as pension, endowment and retirement funds.

To address these concerns in liquid asset portfolios we suggest a portfolio management process that includes a combination of strategic considerations – such as valuations and return premium estimates, with tactical considerations – timely factors based on momentum, sentiment and trading patterns, applied to a portfolio of core equity and fixed income exposures, across asset classes, geographies and investment factors. By managing portfolios across not only asset classes and geographies, but also across investment factors, it is possible to create exposures to a broad array of investment opportunities, with mechanisms in place to reduce drawdowns in tail-risk scenarios.

A full portfolio solution could combine this strategic and tactical approach to the liquid markets portion of one’s portfolio along with a dedicated effort to identify potential high return, uncorrelated, concentrated alpha opportunities. These alpha opportunities may arise due to specific market regime dislocations and disruptions.


AUA Capital Management, LLC does not render legal, accounting, or tax advice. This analysis has been prepared solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Any performance data quoted represents past performance. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Past performance is no guarantee of future results. This data is gathered from what is believed to be reliable sources, but we cannot guarantee its accuracy.

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