True Diversification

Diversification means different things to different investors.

Sure, the “don’t put all of your eggs in one basket” philosophy is universal. Yet, some investors interpret this to mean buying many different types of stocks while others take it to mean looking outside the stock market to diversify their holdings.

Hedge funds get a bad rap in the financial media. And while some of it is deserved (there are plenty of bad apples), these investment vehicles do serve a valid purpose. Of course, the value of hedge funds is easily masked in years like 2013, when buying a low-cost index fund would have made you nearly 30% richer.

Most hedge funds underperformed the S&P 500 last year, mainly because they were doing what they’re designed to do… that is hedge. The bearish hedge positions killed the returnrns of these funds in 2013, making easy targets of any professional money manager who didn’t at least match the stock market’s 30% rise.

Yet, hedge funds will continue to offer investors the chance to diversify… outside of the stock market, to boot.

One niche of the hedge fund industry, called managed futures, seeks diversification by trading upwards of 30 different markets, spanning the spectrum of sectors… from stock indices and bond futures, to commodity and currency markets. And diversification is enhanced by taking both long and short positions in these markets.

Managed futures, as an asset class, has underperformed the S&P 500 over the past twenty years, but outperformed the returnrn achieved by the average investor. Take a look…

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Investment returnrns achieved by the average investor have always lagged the returnrns generated by stock indices. And this underperformance is usually explained by observations of poor, inconsistent and irrational decision-making on the part of the investor.

To combat investors’ natural tendency to muck up their portfolio, many managed-futures funds employ a fully systematic approach, where buy and sell decisions (and risk management tactics) are automated, based on rules and parameters that the fund manager defines in advance, then implemented with an extreme amount of discipline, thus removing the returnrns-sabotaging emotion we all feel when our money is in the market.

This systematic approach, combined with the diversification benefit of trading 30 non-correlated markets, tends to generate returnrns that are less volatile than the stock market.

Here’s a chart that shows this well, by plotting how $1,000 invested in 1990 performed when invested in three asset classes: stocks (grey), bonds (blue) and managed futures (orange).

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As you can see, managed futures funds have returnrned less than stocks, although more than bonds. On the volatility side of the equation, you’ll see managed-futures returnrns are more volatile than bond returnrns, although much less volatile than the returnrns the S&P 500 generated.

So next time you hear someone use the eggs/basket expression, think about investments outside of the stock market as well. By investing in a program with exposure to all markets — on both the long and short sides — you can achieve true diversification.