How Is Your Diversification Doing ? Here's How to Find Out..and Why One can Never Get a Good Answer to that Question with Actively Managed Funds

The American Association of Individual Investors (AAII) has published an excellent article on the importance of portfolio diversification and ways to check it in your portfolio.


Since AAII is a group of  "do it yourselfers" who tend to devote significant time to their investments the article is geared to making use of available tools on the web and doing the analysis oneself.

Most investors haven't taken the time to become "investment nerds" and would prefer to have the analysis done by an investment professional and even those that have may want a "second opinion".

Advisors (like myself) have access to tools more sophisticated than the ones mentioned in the article and can generate an analysis not only giving an evaluation of your current portfolio..but also with specific recommendations for a more diversified..and often lower cost alternative.

Note that with a portfolio of actively management funds one can never know how diversified a portfolio is. Managers change their holdings and often report them only quarterly A true diversification analysis would have to be constantly updated to keep up with changes...and if one makes changes to make the portfolio of active funds more diversified it is like chasing shadows you never can know the real consequences of your changes

Contact me at lweinman@lweinmanadvisor.com if you are interested in such an analysis either in Southern California or Israel in person or via email/skype from anywhere else.

From the AAII (in italics my bolds) full content is herehttp://www.aaii.com/computerized-investing/article/Is-Your-Diversified-Portfolio-Truly-Diversified?a=weekly05172016nm&acc=o

Why is Diversification important ?

The best argument for mutual funds is that they offer safety and diversification. But they don't necessarily offer safety and diversification.—Ron Chernow

Mutual funds—and more recently, exchange-traded funds (ETFs)—have offered safety and diversification by allowing individual investors to buy shares in many companies in order to spread risk. It is important for investors to understand what role they play and what role the fund managers’ play in ensuring proper diversification of their portfolio. Additionally, investors need to understand when fund companies fail on proper diversification, how that results in improper diversification and what impact that could have on their portfolios. We highlight what diversification is and why it is important, then discuss why an appearance of being diversified may not mean that your portfolio is truly diversified. Finally, we identify ways that fund managers and investors can damage their portfolio diversification.

The Importance of Diversification

Diversification reduces risk by allocating investments among various financial instruments, industries and other categories. The theory is that some assets will outperform in certain scenarios while underperforming in other scenarios. The benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated. Correlation is a statistical measure of how two securities move in relation to each other.

Research supports this contention, as is illustrated by the paper by William Goetzmann and Alok Kumar, “Equity Portfolio Diversification,” from the National Bureau of Economic Research. The authors found that investors who held the least-diversified portfolios in a pool of investors earned far less than the most-diversified group of investors....

The study determined that the least-diversified (lowest decile) group of investors earned 2.4% lower return annually than the most-diversified group (highest decile) of investors on a risk-adjusted basis. The economic cost of under-diversification was higher for the group of older investors, where the risk-adjusted performance differential between the least-diversified and the most-diversified investors was 3.1%

What Can a Portfolio Analysis Do For You ?

Checking Your Diversification: An Example

For example, with a four-ETF portfolio that includes iShares Russell 2000 ETF (IWM), SPDR S&P 500 ETF (SPY), Vanguard FTSE All-World ex-US ETF (VEU) and Vanguard REIT ETF (VNQ), I have assembled what, on its face, appears to be a reasonably well-diversified portfolio.
For the purposes of this illustration, the holdings are equally weighted in terms of the number of

Table 1. Sample ETF Portfolio

ETF	Number of Shares	Price per Share	Total Investment ($)	Percentage of Portfolio	Beta
IWM	100	116.55	11,655	26.2	1.27
SPY	100	200.10	20,020	45.0	1.00
VEU	100	51.43	5,153	11.6	1.19
VNQ	100	75.85	7,595	17.1	0.94
Portfolio	400	--	44,423	99.9	1.09

Analyzing Portfolio Diversification In-Depth A Case Study

Using analytical tools which examine not just the actual holdings of the ETFs and funds in a portfolio not simply the categories given to the funds by the management firm gives a true picture of the portfolios diversification. Such an analysis can also take into account any individual stock holdings as well 

International diversification. A well diversified portfolio should be allocated around the world. The US makes up around half of the worlds market capitalization. While some would argue for a geographical allocation there is no one answer. Many experts see 20-30% as the optimal % of non US stocks to hold in a portfolio. Few would recommend a portfolio with no non US stocks. And within the non US stocks most if not all experts advise a mix of developed and emerging market stocks.

While an all ETF portfolio will generally be transparent  with  regards to geographic allocation ( a US stock ETF will not hold non US stocks) that is not the case with actively managed funds which are often if not usually allowed under the terms of their prospectus to invest with a different geographic mix than the ostensible fund category (a US stock funds investing in emerging market stocks for example)

For portfolios with bonds the same would be the case. A "go anywhere" actively managed bond fund or ETF may invest in bonds anywhere in the world while a bond index fund or ETF must match the specified index.

Here is what an analysis of the above portfolio would look like

Figure 1. Sample ETF Portfolio Geographic Breakdown

Source: Morningstar.com X-Ray.

The analysis  shows us that 89% of our sample ETF portfolio is U.S. stocks (Figure 1). This may or may not be a geographic diversification issue, depending on your risk tolerance.

Stock Diversification by Sector

An indepth analysis can also look inside the porfolio and check for other types of diversification

The analysis ..

indicates the sector percentage for the companies held by the ETFs. For example, it indicates that 47% of the companies represented in the portfolio are in a cyclical type of sector such as basic materials or financial services (Figure 2). Again, as an individual investor it is important to understand what your risk tolerance is compared to what the tool is showing you. Cyclical sectors can perform quite well when the economy is expanding, but can perform quite badly when the economy is weak. The holdings for a benchmark, typically the S&P 500, are also provided for some perspective....
What you are likely to see is significant differences between weights by sector for the broad index compared to your holdings. It is important to understand how those differences can affect your portfolio. For example, as we mentioned above, our self-constructed portfolio has 47% of its holdings in cyclical companies. The S&;P 500 index maintains only 31% in cyclicals. That is a very significant difference and will affect returns and volatility

In the example here the portfolio is comprised solely of ETFs but many portfolios include actively managed mutual funds and individual stocks making this type of "xray' analysis more important in understanding a portfolio's diversification.

In some cases an advisor might advocate changes in the portfolios's holdings to reduce a high allocation to a particular industry because of holdings in company stock or options. Because of taxes or other restrictions it might not be practical to sell the company stock so other adjustments can be made with a portfolio of transparent ETFs.

Figure 2. Sample ETF Portfolio Sector Breakdown

Source: Morningstar.com X-Ray.

In the case of our presumed “well-diversified” portfolio from above, we can see immediately on the X-Ray report that a critical error was made during construction of the portfolio. By equal-weighting the ETF shares in our portfolio, the report shows that we have 10 times the weighting in real estate that the S&P 500 has (Figure 2). In addition, we were apparently not aware that broad ETFs like SPY and others hold real estate. While REITs have, since 1971, returned 11.9% per year on average according to Ibbotson Associates (second only to small-cap stocks) and allowed investors a liquid way to gain exposure to real estate, this is more allocation to REITs than we thought. Being heavily overweight in real estate makes the portfolio vulnerable to the vagaries of that asset class. Is that what we thought we were getting? No? Surprise!

The above example shows the "surprise' high weighting of real estate in the ETF portfolio. Doing a similar analysis on a portfolio with actively managed funds is likely to lead to even more"surprises"

Style and Market Capitalization:

Although not included in this article a portfolio analysis will also show the breakdown of the portfolio by size market capitalization and valuation measures. A diversified portfolio should include large and small cap stocks but an analysis of a portfolio may show a very low representation of small and mid cap stocks.

I have written about the perils of market capitalization portfolios that are top heavy with large cap growth stocks. A portfolio analysis can give an excellent idea of the actual holdings of the portfolio broken out by categories such as large small and mid cap and value vs growth stocks. It can also give specific etrics such as market capitalization, price earnings ratio and price to book.

There is a significant body of research showing that over the long term value stocks especially small cap value stocks outperform the market capitalization weighted indices. This analysis can show if a portfolio is positioned to take advantage of this potential outperformance.

Don't Forget the Bonds

A diversification analysis can also breakdown the bond holdings in a portfolio in terms of geographical diversification, maturity/duration , types of bonds and credit quality. Without performing an analysis of an entire portfolio it is impossible to know the potential impact of changes in exchange rates, economic conditions,and interest rates on a bond portfolio.

This analysis is particularly important if a portfolio includes an actively managed mutual fund where even a fund labelled a US Investment grade corporate bond fund might hold non US corporate bonds. In the case of "go anywhere' bond funds getting a handle on the actual portfolio allocation is even more important.


The Added Perils of Using Actively Managed Mutual Funds in Both Stocks and Bonds.

Actively managed mutual funds frequently have "style drift" in which their holdings differ from the category label of the fund for example a small cap value stock fund with a significant allocation to large cap growth stocks.

The same holds true for bond funds which may drift out of their style category. "Go anywhere" bond make understanding a portfolios bond diversification difficult if not impossible since they can drastically and frequently make major changes in the portfolio for instance going from a zero weighting in non US dollar denominated emerging market bonds to a significant weighting.


 Additionally since the fund is "actively managed" an analysis such as the one may be instantly out of date . In fact since actively managed funds report their holdings with a lag the portfolio analysis likely wont even reflect the actual portfolio at the time of the analysis (which of course can only be based on reproted data). In other words even with this great analystical tool creating a properly diversified portfolio of actively managed funds is like a game of "whack a mole" everytime you correct a lack of one type of diversification another cause of poor diversification emerges.

Analysis Must Be Combined with Action

The in depth analysis here is not a mere academic exercise it is a tool to show where changes need to be made to create a properly diversified portfolio.

A complete diversification analysis such as the one I perform for clients presents a before and after portfolio. That means an analysis of the diversification of the existing portfolio and recommended adjustments to make the portfolio more diversified..and another report similar to the one descirbed here analyzing the proposed portfolio after changes are made.

Rebalancing: Wash Rinse Repeat

The movement of the various holdings in a portfolio can drive a portfolio away from the target allocationa and level of diversification. An annual diversification analysis can keep the portfolio in line with the proper level of diversification by showing where rebalancing needs to be done.

The AAII article concludes:

Summary

We have learned that while portfolios can be constructed that appear to be diversified, digging deeper can show that the diversification is not appropriate for the investor’s needs. It is incumbent upon the investor to educate themselves not only on how to construct a well-diversified portfolio, but also on how to keep it well-diversified over time. While a fund manager may take actions that can result in improper diversification for the fund’s investors, there are things that investors can do to minimize the chances of improper diversification. Actions such as monitoring correlations and automatically reinvesting dividends, while not huge actions, can pay off in spades by keeping the portfolio appropriately diversified. The key is to be an educated investor.