Over the last several years, many investors discovered, to their unfortunate surprise, that their portfolios were not nearly as protected from downside risk as they thought and that their traditional idea of "diversification" fell short.

As part of our efforts to educate investors on what we call "The New Diversification," we recently spoke with Professor Christopher Geczy, Academic Director of the Wharton Wealth Management Initiative and an Adjunct Associate Professor of Finance at The Wharton School. Highlights from our conversation are below:

Open Your Eyes Question 1


What happened during the credit crisis? Did the entire concept of Modern Portfolio Theory fail?
It's a great question, and my answer is an emphatic "no." Modern Portfolio Theory did not fail—if anything, portfolio construction did. Portfolio construction is challenging enough to begin with, and it's even harder during times of crisis, when correlations can work against investors.

What happened to some investors during the credit crisis and the "great recession" is really all about what I would call the "physics" of diversification, by which I mean that increases in volatility are often naturally related to increases in correlations.

As an example, take a look at what happened to correlation measures during the two significant bear markets of the last 10 years—correlations between many individual investments and even asset classes spiked closer to 1 (with 1.0 representing a "perfect" correlation and -1.0 representing a "perfect" negative correlation).

Correlations Climb During Times of Crisis


Open Your Eyes Question 2


But these sorts of correlation issues aren't limited to times of crisis, correct?
That's absolutely correct. While correlations do often spike during times of stress, they can also be surprisingly high over full market cycles. The chart below shows the same correlation results during the last 15 years, and while the correlations between asset classes are lower as a whole over this longer time period, they are still quite high.

Correlations Can Be High Over Market Cycles


Open Your Eyes Question 3


So why did some portfolios perform so poorly during the crisis?
When volatility rises, so too can the correlations between US and international stocks, which is the reason nearly all markets suffered significant downturns during the great recession. It also goes beyond asset classes like US and international stocks and bonds. Using the same time periods we were discussing before, we can see what happened to an "undiversified" portfolio of large-cap US stocks and broad-market US bonds compared to a more "diversified" portfolio that also included a range of other stocks and bonds—there really wasn't much difference in terms of the experience of the investor. In fact, a so-called "diversified" portfolio fared slightly worse during the recent credit crisis.

Traditional Diversification Lacks When Volatility Rises


Open Your Eyes Question 4


Does this mean that there's really no such thing as diversification?
Not at all. And to be clear, I'm not saying there is no benefit to investing in different asset classes, different regions and so on. Certainly, a traditional 60% stock / 40% bond portfolio would have done better during the credit crisis than a 100% stock portfolio and may better fit the risk profile of certain investors. At the same time, over the same 15-year time period we discussed earlier, a traditionally diversified portfolio would have outperformed an undiversified portfolio, even if it didn't really provide much in the way of downside protection.

Diversified Portfolios OutPerformed the Last 15 Years

The point I'm making is that investors cannot necessarily rely on what is traditionally thought of as diversification to meet their long-term goals.

It is also important for investors to understand the sources of risks in their portfolios. The chart below shows that over the last 15 years, the correlation of returns between a 60/40 portfolio and a 100% equity portfolio was 0.98, meaning that they were almost perfectly correlated. Even a portfolio that is exceptionally overweight shows a similar trend. A 30% stock / 70% bond portfolio had a 0.85 correlation to a 100% stock portfolio. To me, that says that a long-only stock and bond portfolio isn't full diversification.

Balanced Portfolios Correlate Strongly


Open Your Eyes Question 5


What does it mean to have exposures to multiple risks?
The objective for investors should be exposure to a variety of risks, in proportion to their risk preferences and circumstances. In other words, investors should hold as many different assets and exposures as they possibly can, according to their specific circumstances.

This doesn't mean that all risks are the same and it doesn't mean that investors should necessarily equal-weight their portfolios among all of these risks. Investors need to work with their financial professionals to choose and blend the risks that make sense for their unique circumstances.


Open Your Eyes Question 6


How you would define alternative investments?
Most people think of "alternatives" as a single asset class or strategy. In fact, they are not. Alternatives provide access to sophisticated investment strategies and types of investments that cross asset classes, broaden diversification opportunities and potentially widen portfolio correlations. I would rather define alternative investments as core diversifiers, sources of potential return and investments that provide risk exposures that, by their very nature, have a low correlation to something else in an investor's portfolio.

If we think of alternatives in this way, they are no longer exotic types of investments that most people will never be able to access, but rather they become instruments available to all investors designed to help diversify portfolios by taking on different types of risks.


Open Your Eyes Question 7


What sort of assets would you include in your definition of alternative investments?
This is a question that really takes the discussion from the more theoretical to the practical. And so, from a practical perspective, I think I would agree with the notion that an alternative investment can be anything other than a long-only equity or long-only bond investment.

As I've said before, the concept of alternative investing is really about going beyond what a traditional 60/40 portfolio might look like by either going long on assets that are not already present or by engaging in trades that provide a new source of diversification.

Enhanced Definition of Diversification


Open Your Eyes Question 8


How should individual investors incorporate some of these "new diversifiers" into their portfolios?
Individual investors are fortunate in that the past couple of years have witnessed the advent of a number of the strategies we are talking about in a mutual fund or related structure, including commodities and currency-related funds, long/short strategies and specialized equity and fixed income investments. These are products designed for individuals and that mitigate illiquidity and transparency concerns while still seeking out sources of diversified risks.

Alternative Investments Fared Better During the Crisis


Open Your Eyes Question 9


Are there any down sides to investing in these sorts of strategies in a mutual fund?
Well, there certainly are some types of investment strategies that wouldn't fit easily into a mutual fund vehicle due to their investment characteristics or legal restrictions on these funds. Mutual funds also have certain restrictions on leverage, which create some management limitations.


Open Your Eyes Question 10


If an individual investor wants to consider alternatives, what should they look for in an asset manager?
Choosing the right asset manager is always important, and I would argue that it's even more critical when selecting someone to manage an alternative investment or any sort of highly specialized strategy.

I really think that only managers that have operational excellence, that have robust risk management systems and that have rigorous compliance controls should be operating in this space.


Please consider the investment objectives, risks, charges and expenses of each fund carefully before investing. The funds prospectuses and, if available, the summary prospectuses contain this and other information about the funds and are available, along with information on other BlackRock funds, by calling 800-882-0052. The prospectus and, if available, the summary prospectuses should be read carefully before investing.

Diversification and asset allocation may not protect against market risk or loss of principal.

The opinions presented are those of Professor Christopher Geczy as of April 2014, are not necessarily those of BlackRock or The Wharton School, and may change as subsequent conditions vary. Individual portfolio managers for BlackRock may have opinions and/or make investment decisions that, in certain respects, may not be consistent with the information contained in this report. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance does not guarantee future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.

International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are often heightened for investments in emerging/developing markets or smaller capital markets.

Incorporating alternative investments into a portfolio presents the opportunity for significant losses. Also, some alternative investments have experienced periods of extreme volatility and in general, are not suitable for all investors.

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