Don’t Buy and Forget (About Diversification)
Koch Capital believes that your clients will get the most out of their investment dollars by diversifying globally rather than holding a U.S.-centric asset allocation. By diversifying a portfolio to include international and emerging markets asset classes of all market capitalization sizes, as well as alternative investments like real estate, currency, volatility, leverage, momentum and commodities, retirement investors may be able to increase portfolio returns by 1–2% annually. This observable performance benefit, which we have labeled “Buy and Diversify” in our chart below, is known as the diversification premium.
If the first 1–2% of return improvement comes from better diversification, then how do you know if your portfolio is truly diversified? The answer is robust portfolio metrics that go beyond traditional portfolio beta and price volatility, drilling down on asset class correlations in both good and bad times. This in-depth portfolio analysis and optimization not only provides better risk-adjusted returns but also generates more stable returns in the long run.
We believe our “real diversification” approach provides an additional one to three years of withdrawal power from a portfolio during retirement, in addition to reducing portfolio volatility. We also believe that a less volatile (low beta) portfolio reduces the likelihood of an emotional, reactive decision by an investor to sell low and buy high.
Tilt but Verify
Improving portfolio returns by 1–2% annually through better diversification is just the first step. Adding strategic allocation tilts (overweight or underweight specific asset classes based on forward-looking market projections) and periodic portfolio rebalancing should further improve portfolio performance. However, this “Buy and Tilt/Rebalance” strategy is more challenging and expensive to execute effectively, in our opinion, given the difficulty in accurately forecasting future asset class valuations and in identifying and controlling portfolio costs, including advisor fees, fund expenses and trading costs.
In addition, if the “Buy and Tilt/Rebalance” strategies are employed incorrectly, the investor’s portfolio may suffer potential premium loss as well as fee drag. We believe that the more ad hoc tinkering of a portfolio’s allocation without robust quantitative analysis, the greater chance of reducing performance and adding unnecessary volatility.
Limited Tactical Hedging
By adding active portfolio hedging to the equation (labeled “Buy and Hedge” in the chart), incremental return improvements become even harder to achieve, in our opinion. In addition, if the hedging strategy fails, you may further reduce the return premium and create even more fee drag.
This doesn’t mean that active hedging is without merit (it can be effectively used to provide downside protection, for example). However, it’s extremely difficult for any portfolio manager to hedge 100% of a client’s portfolio effectively year in and year out. This is why, along with their high fee structure, it is difficult for hedge funds to consistently beat their benchmark indexes in the long run, in our humble opinion. We limit our tactical hedging strategies to just downside protection and to no more than 20% of a client’s portfolio.
Expert Active Management
The final level of portfolio return improvement is what we call “Expert Active Management.” This highest level of portfolio return improvement is reserved for those portfolio managers like Warren Buffet and Peter Lynch who consistently provide above-market returns decade after decade. Unfortunately, Koch Capital does not possess the same stock-picking prowess, but we believe we don’t have to in order to help your clients reach their financial goals. What we do provide are well-diversified, strategically tilted and rebalanced portfolios at a reasonable cost, and the know-how to apply the appropriate strategies for your unique financial situation. We describe in detail our 10 different portfolio strategies in the Strategies section of our website.
DISCLOSURE: Information provided reflects Koch Capital’s views as of the date of publication. Such views are subject to change at any point and Koch Capital shall not be obligated to provide notice of any change. Koch Capital is not responsible for the consequences of any decisions or actions taken as a result of information provided in this piece and does not warrant or guarantee the accuracy or completeness of the information requested or displayed. The opinions referenced herein are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered a recommendation to buy or sell any securities. Nothing presented herein is or is intended to constitute investment advice, and no investment decision should be made based on any information provided herein. Koch Capital has not taken into account the investment objectives, financial situation or particular needs of any individual investor. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses.