The first six months of 2022 have been tough for investors with sharp drops across both equity and bond markets. The last time US equities recorded a similar fall in the first six months of a year was sixty years ago at which time President Kennedy was facing escalating tensions in Cuba between the US and the Soviet Union. Things have been no better for US sovereign debt which recorded the worst first six months for a calendar year since the US Constitution was ratified in 1788, a year before the US Treasury was founded!
It has, of course, not only been US financial markets that have suffered. The bar charts below show the widespread losses recorded for H1 2022 across major asset classes and regions in local currency and in Sterling.
It was seventy years ago that Harry Markowitz introduced the world to modern portfolio theory in his article published in The Journal of Finance entitled “Portfolio Selection”. His ideas fundamentally changed the way people invested, won Markowitz a Nobel Prize, provided a mathematical justification for portfolio diversification and prompted economist Peter Bernstein in 1992 to describe his contribution as “the most famous insight in the history of modern finance.”
But what works over the longer term does not necessarily hold true over shorter periods; and we have just experienced such a period. There have been few hiding places. Of the sixteen asset classes modelled above, just two rose during the period: commodities and gold. Even hedge funds, on average, suffered.
The graphic on the following page seeks to place the severity of the downturn in financial markets in the first six months of 2022 into historical context. It presents a patchwork of returns for 16 asset classes over the 37 discrete six month periods since the commencement of the ARC Private Client Indices in 2003. Results are shown in Sterling terms. A blue square indicates an above average return; an orange square indicates a below average return. The intensity of the colour reveals the size of the deviation from the average.
The chart reveals that financial market losses in the first six months of 2022 were unusually widespread and unusually severe with only commodities and gold providing Sterling investors with positive returns. Note that, once again during financial market turmoil, Sterling weakened and those investors with an international bias would have benefited from a strengthening of the US Dollar versus Sterling of 11.5% over the period.
Another way of revealing the unusually negative performance of nearly all asset classes during the last six months is to plot H1 2022 returns by ranking the return from each asset class versus the previous 36 discrete six month periods since December 2003. The grey bars represent the spread of returns covering the second and third quartile. The lines extending out plot the 10th and 90th percentile results. The latest results are shown as Blue (positive) and Orange (negative) dots. Note that for nine of the 16 asset classes the last six months’ losses are amongst the worst recorded. Only commodities delivered unusually high returns for the period as a counterweight and only commodities have a negative average six monthly return over the period.
Markowitz Magic
In the context of extremely challenging markets, over the last six months discretionary portfolio managers have generally struggled across all four of the ARC PCI risk categories to contain losses. Even top quartile managers have seen negative returns and double digit losses have been all too common. These performance characteristics led us to ask the question of whether old fashioned asset class diversification would have been of any help. What if discretionary managers had followed the 70 year old insight of Harry Markowitz? How might a manager have performed had they been using, say, returns since December 2003 to construct discretionary portfolios with risk profiles the same as the four ARC PCI indices using just ETFs tracking the 16 asset classes set out above?
The efficient frontier plots the highest return for every risk level. UK short dated gilts are the orange dot on the left of the chart and world equities are the blue dot top far right. The four ARC PCI averages are placed somewhat below the efficient frontier, the performance gap rising as the risk level increases.
The yellow dots are Reference Indices that represent combinations of the 16 ETFs designed to mimic but not mirror the four ARC PCI risk categories. So now let’s compare and contrast the performance of the average discretionary investment manager versus the diversified combination of ETFs over the last 6 months. The results are intriguing and suggest that private client discretionary managers had moved away from diversified portfolios over the last decade or more towards more concentrated factor exposures.
The chart plots the range of outcomes across the universe of discretionary managers who contribute to PCI in each of the four PCI risk categories. The grey bar shows second and third quartile outcomes; the grey line extends that to the 10th and 90th percentile. Into that outcome dispersion the performance of the four diversified ETF reference indices is shown in yellow.
There are perhaps two key observations to make here:
Conclusions
So what can be concluded from this analysis?
It seems that the QE era was a time when Markowitz magic was forgotten. Buffettology became the dominant investment philosophy. There was perhaps some evidence of a small performance pick up available from a more concentrated approach to portfolio construction but, on average, that has more than reversed as financial markets have sought to react to a clear regime change.
Whether longer term concentration will prove the better approach is hard to say! Peter Lynch, the fund manager of the Magellan Fund at Fidelity Investments between 1977 and 1990 consistently delivered twice the annual return of the US equity market and in his book “One Up On Wall Street” coined the term 'diworsification' referring to the process of adding investments to a portfolio in such a way that the risk-return trade off is worsened. That is undoubtedly true if a fund manager exhibits skill and an ability systematically to generate positive alpha over time.
Concentrated portfolios have come into vogue over recent years but what the last six months have shown is that even significant historical outperformance can be rapidly reversed.
Investors seeking a smoother ride should carefully consider the words of Buffett that diversification is a protection against ignorance. Buffett might have meant that concentration is king but another way of looking at this statement is to ask how confident you are that your manager is not numbered among the ignorant! Why refuse the free lunch of reduced risk that diversification provides?
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