The “great bear market” in diversification follows Wall Street professionals

(Bloomberg) — They did everything right — spreading bets too wide across bonds and stocks in case things went south. Now, after heeding Wall Street’s mantra to diversify for too long, these investors are watching with envy as the rally in U.S. stocks leaves them back in the dust.

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The numbers are grim. Money managers who obeyed the old wisdom of the financial industry to separate investments across markets and geographies are on an epic losing streak versus those who simply bought the S&P 500 and sat back. In one example, of roughly 370 asset allocation funds tracked by Morningstar Inc., only one has managed to beat the index since 2009.

It has been a great lesson in futility, rather than a disaster in itself. Diversified portfolios have still managed to return about 6% per year throughout this period, going by a model held by Cambria Funds. However, the streak of underperformance is becoming historic — and could get worse as the AI-backed equity meltdown continues. Overall, diversified portfolios have trailed the U.S. large-cap stock index in 13 of the past 15 years, a stretch seen only once before in nearly a century of data, per Cambria.

“If your neighbor has all his money in the S&P, then you look like a fool,” said Meb Faber, founder of investment firm Cambria and an expert on portfolio theory.

For small investors and big money managers alike, the psychological scale of falling behind creates pressure, especially for those sticking to the playbook. Institutions from pensions to endowments and foundations have $21 trillion hidden in diversified conventional strategies that allocate money across a wide range of investments, including bonds, stocks, real estate and cash, a recent study by Preqin showed.

Yes, house bets on US stocks look risky as Nvidia Corp. and other tech megacaps dominate the world’s largest stock market, posing an unprecedented risk of concentration. At the same time, elevated Treasury yields provide a potential buffer if stocks stage a big crash. And yet, fans of diversification are plagued with doubts. US stocks remain the only game in town year after year, thanks to the reliable profit engine of Corporate America. Mastering anything else has been a path to poor performance.

Faber calls the past 15 years a “diversifying bear market.” His $54 million Cambria Global Asset Allocation (GAA) ETF has trailed the S&P 500 in all but one year since its inception, despite a 5% annual gain.

While history has instances of similar scams being resolved in favor of diversification, the wait has been particularly long this time.

These days, financial advisors like Anthony Syracuse often find themselves having to rein in clients eager to follow the Big Tech rally given strong valuations versus the rest of the market.

“This can be an extremely difficult conversation,” said Syracuse, founder of Dynamic Financial Planning. “Everyone wants to maximize their profits.”

US stocks have been on a strong run since the global financial crisis, outperforming almost everything in a period when bond returns were crushed during the zero-rate era while international stocks weakened under the weight of a strong dollar. At 14% a year, the S&P 500’s return is twice that of emerging-market stocks and adds up to three times that of investment-grade bonds.

Against this backdrop, almost everyone exiting US stocks is subject to a sense of loss. Over the past 15 years, the PIMCO StocksPLUS Long Duration Fund (PSLDX) is the only one among the 372 asset allocation portfolios tracked by Morningstar that is ahead of the S&P 500.

The data has encouraged those who say diversification — however sound in theory — is costing investors over the long term, holding onto underperforming investments. The uproar spread last year when academics published a study saying retirees would be better off avoiding bonds altogether.

Proponents of modern allocations pushed back, saying assets like fixed income allow individual investors to better match financial gains with future liabilities. Additionally, diversified portfolios gained from 2000 to 2008, a period when stocks saw their values ​​halve on two separate occasions.

“Diversification is your best friend on your worst day,” said David Kelly, global chief strategist at JP Morgan Asset Management. “Proper asset allocation is a bit like home insurance. You never know when you’ll need it, but you should never be comfortable not having it.”

This logic is partly what lies behind the decision of many big money professionals, who periodically adjust holdings in order to return to the desired level of asset allocation.

Of course, pure returns aren’t the only thing that matters. Another consideration is how much turbulence must be endured in order to make a profit. Based on a measure of risk-adjusted returns known as the Sharpe ratio, Cambria’s global asset allocation model has actually outperformed the S&P 500 since 1927.

But things began to change after the Federal Reserve rushed to bail out the market during the crisis of 2008. Since then, the S&P 500 has staged an almost uninterrupted rally with mostly subdued volatility, posting a higher Sharpe ratio.

“The question everyone has is, does diversification make sense?” said Mayukh Poddar, senior portfolio manager at Altfest Personal Wealth Management. “Many people have become more focused on stock market returns in the post-Covid era.”

Within diversified portfolios, many clients are growing skeptical about the benefits of investing in small-cap and non-U.S. stocks, according to Que Nguyen, chief investment officer for equity strategies at Research Affiliates.

“What we’ve seen over the last 15 years is that big gets bigger,” she said. “You don’t want all your eggs in one basket, but it’s hard to keep faith.”

In some quarters, the haven status of fixed income is also being questioned, as the asset class sank along with stocks during the 2022 inflation sell-off.

Inflation is likely to remain sticky, making bonds exposed at a time when the government is increasing its Treasury supply to meet fiscal needs, according to David Rogal, a portfolio manager at BlackRock Inc.

“It’s very clear that the bond market has become less reliable as a hedge in a portfolio,” Rogal said at a recent panel discussion hosted by the MacroMinds Foundation.

It is tempting to put an end to capital growth, given the prospect of stretched valuations and tight monetary policy. However, the S&P 500 has maintained its leadership this year, delivering a gain that is again ahead of the rest of the world and contrasted with losses in Treasuries.

According to Cambria’s Faber, there are signs that US investors are adjusting to the new regime, including a deepening home bias and a willingness to let stock holdings grow to record highs. Meanwhile, big money managers are moving into alternative assets, such as private equity firms, as a way to improve performance.

“There’s no expiration date on this” equity boom, Faber said. “The institutions are leaning heavily on this, but the savior they’re looking for is private equity, which is basically American stocks.”

– With the help of Isabelle Lee.

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