DC
Diversifiers:
By
Rick Wurster,
CFA, CMT
Asset Allocation
Portfolio Manager
Wellington Management
Company, LLP
Stabilizing Performance
Across Environments with
Absolute and Total Return
The conventional way to diversify an investment portfolio is by asset type
— equities, bonds, and cash, sometimes with the addition of alternatives
such as commodities and real estate. The typical outcome of this approach,
however, is that risk in the portfolio is dominated by exposure to equities. A
2030 target-date portfolio, for example, may have an 80% equity/20% bond
split, yet stocks are the source of virtually all of the portfolio’s risk (Figure
1). Even in a portfolio with a more conservative 50/50 mix of equities and
bonds, equities make up fully 87% of total risk. The reason for the wide gap
between a portfolio’s asset allocation and its risk distribution in such cases
is that equities are much more volatile than bonds, historically displaying
triple the variability.
What are the consequences of this overconcentration in
equity risk? Portfolios are too heavily influenced by the
equity market. Historically, an 80% equity/20% bond portfolio has had a correlation to equities of 1.00. That is fine
in bull markets, but problematic in choppier markets. To
make a portfolio more stable across market environments,
we think it should be constructed with balanced risk exposure to four asset categories: growth assets, defensive assets,
inflation hedges, and the focus of this article, diversifiers,
including absolute-return and total-return strategies.
Risk in Most Portfolios Is
Overconcentrated in Equities
Typical 2030 Fund Typical 2010 Fund
100
20
1
3 100
8
5
FIGURE 1
80
80
50
Percent
40
60
60
96
80
40
87
50
20
20
Asset Mix Contribution to Risk
0
Equities (MSCI World Index)
Bonds (Citigroup World Govt Bond Index)
Active Risk
0
Asset Mix Contribution to Risk
Sources: MSCI, Citigroup, Wellington Management
SPONSORED SEC TION
Benefits of Adding Diversifiers
Absolute-return and low-correlation total-return strategies are
designed to produce positive returns regardless of the market environment. If implemented successfully, they offer four
important benefits for DC participants:
; ; improved risk-adjusted return;
; ; a reduction in overall volatility and downside risk;
; ; less reliance on equities and bonds; and
; ; increased consistency of returns.
While absolute- and total-return strategies have similar
objectives, they also have important differences. Total-return
strategies will tend to incorporate some market exposure,
while absolute-return strategies will generally be market neutral. The market exposure of total-return strategies should be
variable, highly flexible, and based on the manager’s outlook.
Absolute-return strategies will generally be more relative-value oriented and have a portfolio beta to equities and other
assets of close to zero.
As you can see in Figure 2, based on our five-year capital-market projections and assuming 7.5% annual returns for an
absolute-return strategy with 7.5% risk (volatility), the addition
of such a strategy to a typical glidepath would meaningfully
reduce volatility with only a small reduction in return. Even if
we apply more conservative assumptions, the diversification
benefits are still significant. Assuming a 6.5% annual return
for an absolute-return strategy with 9% risk, for example, a
2010 target-date portfolio would still have 25% less risk and
only 5% less return than a traditional mix with greater equity
exposure (see Figure 2 for allocation assumptions).
