Investment Strategy

Diversification Would Have Helped in the Market Swoon, But Not Much

A number of years ago I was commissioned to read and write a review on the book The Ivy Portfolio by Mebane Faber. The book itself looked at the endowment funds of schools in the Ivy League with a particular focus on Yale and Harvard. The endowment funds have a long history of outperforming the overall market, most mutual funds, and most hedge funds.

One of the main tenets of the portfolios is based on diversification among different asset classes. Now, don’t quote me on these being the exact groupings because it has been seven or eight years since I read the book and I couldn’t find my copy yesterday. As I recollect there were five asset classes: domestic stocks, international stocks, fixed income, commodities, and real estate or REITs. Obviously the breakdowns were not just buying an S&P 500 fund and an international fund, etc., so the results would vary based on the stocks in the portfolio, which commodities were in the portfolio and so forth.

One of the reasons the endowment fund portfolios have performed so well over the years is that they avoided big losses. When the market dropped so much from 2000 to 2002, the portfolios performed much better. The same was true in the bear market from 2007 to 2009.

The diversification among asset classes is one of the reasons for the stability in a market like we saw in the last bear market. If you look at the performances of the main sectors during the last bear market, diversification among the different sectors would not have helped all that much. I looked at nine of the 10 main sector SPDR ETFs and how they performed from October 1, 2007 through March 6, 2009. The communication services sector SPDR wasn’t around yet, so that is why I looked at nine of the 10 sectors.

During that bear market, the consumer staples sector was the best performer and it fell 27.81%. The financial sector was the worst performer and it fell 81.43%. The S&P 500 SPDR fell 54.02%. Obviously if you were invested heavily in consumer staples and not invested in financial stocks you would have done better, but you would have still taken a pretty big hit.

In order to look at how diversification would have looked during the current market situation, I put together a list of 10 ETFs that I felt represented the five asset classes that I laid out above. I used the S&P 500 SPDR (NYSE: SPY) and the iShares Russell 2000 ETF (NYSE: IWM) for domestic stocks. I used the iShares EAFE (NYSE: EFA) and the iShares Emerging Market ETF (NYSE: EEM) to represent international stocks. For bonds I chose the iShares 20+ Year Treasury ETF (NYSE: TLT) and the iShares Investment Grade Corp. Bond ETF (NYSE: LQD). Commodities are represented by the Invesco Opportunity Yield Commodity ETF (NASDAQ: PDBC) and the SPDR Gold Trust (NYSE: GLD). Finally, for real estate I used the Schwab U.S. REIT ETF (NYSE: SCHH) and the iShares U.S. Real Estate ETF (NYSE: IYR).

So how did a portfolio equally weighted among these 10 ETFs perform in the recent fall? It did perform a little better than the overall stock market. The big jump in government bonds helped the portfolio as did gold. Poor results from the real estate class hurt and so did the small cap Russell 2000 ETF. The S&P itself was down 22.87% from the beginning of the year through the close on March 25. The diversified ETF portfolio would have fallen just over 17% during this same stretch.

Again, I don’t mean to use these examples as if they represent what the Ivy League endowment portfolios may have looked like. I am using these examples to show how diversification among asset classes can help investors protect the downside in a volatile period.

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