To improve portfolio diversification, look to technology

Traditional, institutional, buy-and-hold asset allocation model isn't the best fit for all clients.

Today’s market environment presents a host of challenges to advisers that necessitate embracing a new approach to portfolio construction — particularly when it comes to diversification — to improve client outcomes.

The reality is that the traditional, institutional, buy-and-hold asset allocation model isn’t the best fit for all clients. True diversification means having a game plan that takes all of the “what-if’s,” market environments and emotional swings inherent in investing into account.

EXTREME MARKET EVENTS ARE THE NEW NORMAL
Today’s markets are more complex, fast-moving and unpredictable than ever before; however, investors’ general objectives are largely unchanged: they want portfolios that will increase in value and reduce the risk of losses. Diversification has long been a fundamental tool for realizing that goal. The idea, of course, is that having a mix of asset classes and categories in a single portfolio will keep it balanced. When one type of asset declines in value, others increase, protecting against overall losses while capturing returns.

(More: When underperforming the S&P 500 is a good thing)

In an environment where volatility and extreme events like the market shocks of 2001 and 2008 are increasingly becoming the norm rather than the exception, advisers will need to look past the traditional diversification process to achieve up-and-down market diversification in clients’ portfolios.

DIVERSIFICATION MORE COMPLEX
In investing, risk is the potential for loss. The best way to measure loss is through drawdown, which looks at the difference in an investment from its market peak to trough during a specific time period. Focusing investors’ attention on drawdown and thresholds for loss simplifies the concept of risk — and makes it easier to measure and manage.

The traditional “style box” mix of equities (large cap value, large cap growth, small cap value, small cap growth) is popular because it works most of the time. Unfortunately, during extreme down markets, traditional asset allocation can produce significant portfolio losses, and most investors have learned the hard way that it can take many years to fully recover.

Yes, an investor with a traditional equity/fixed-income portfolio who remained in the market after the 2008 crash (or an institutional investor with a practically infinite time horizon) would have recouped those losses by now. But for many individuals who were nearing or in retirement, the timing of the down market had a more profound negative impact because of their shorter time horizon.

Strategies that utilize a tactical approach offer a more real-time method for managing risk. However, attempts to be tactical at the end portfolio level can lead to massive failures. An adviser who builds a diversified portfolio — whether active, passive, or both — and then uses a single method to try and reduce the client’s exposure to systematic risk leaves what might be a great portfolio design dependent on just one methodology to manage overall risk. Furthermore, the actual implementation of a system where advisers make short term, tactical portfolio adjustments is far from efficient.

When it comes to managing risk, the principle of diversification still applies — and is perhaps more critically important than ever — but must be approached in a much more in-depth and analytical way on a client-by-client, investment-by-investment basis. And with a growing variety of increasingly specialized vehicles available to meet clients’ needs, advisers have no excuse not to evolve their approaches from the outdated models of yesteryear.

With the enormous variety of investment products available today, achieving up-and-down market diversification for each individual client can seem like a daunting task — and would be, if not for the power of emerging technologies to drive efficient, in-depth research and analysis.

OPPORTUNITIES VIA TECH
Just as everyday consumer products have “gotten smarter” thanks to advances in technology, so can investment portfolios. Advisers should embrace the possibilities and new approaches that technology creates with regards to the process of diversifying clients’ investments.

There is no limit on what can be tracked and quantitative methods make it increasingly possible to rapidly analyze large volumes of information.

Advisers should look for managers and strategists who use technology to aggregate market signals in the tactical universe and automatically use that data to adjust their positions. These quantitative strategies can also be tested backward in time to examine how and when they take action. This “in-sample experience,” i.e., tracking models and running conceptual strategies in real-time, is an extremely valuable analytical tool made available by recent innovations.

The field of data analytics is evolving at a rapid clip, and that spells tremendous opportunity for the financial services industry. Advisers who recognize these opportunities and embrace new ways to achieve investors’ goals will be the ones who truly deliver for their clients.

Jerry Murphey is co-founder, president and CEO of FolioMetrix.