Is equity diversification dead?

One money manager who has little faith in equity diversification strategies is AGF's Christine Hughes

By Dale Jackson
Globe Investor Magazine Online
Jan. 8, 2009

It's a blues tune a lot of investors have been singing after watching their stock portfolios plunge in 2008 in what seems to be equal portions. It turns out that old saying about rising tides lifting all boat works in reverse - in fact, all boats are under water.

Conventional wisdom tells us we can limit risk in our investments by diversifying - but that simply hasn't been the case in equities.

If the stock market meltdown was a blues song it would go like this:

"I put my money in energy - da na na na,

It dropped 41 per cent.

Bought some information technology - da na na na,

It fell 51 per cent.

Went for emerging markets - da na na na,

They dove 49 per cent."

And the jam session goes on and on. Last year's market meltdown was broad and indiscriminate. On average, Canadian real estate stocks fell 46 per cent, European stocks plunged 52 per cent, global small caps lost 34 per cent and U.S. consumer discretionary stocks took a 35-per-cent nosedive.

The only sectors to deviate from a range of minus 30 per cent to minus 60 per cent were consumer staples (down 11.2 per cent in Canada, down 19 per cent in the U.S.), Canadian utilities (down 27 per cent), U.S. health care (down 26 per cent) and Canadian metals and mining (down 69 per cent).

Even style diversification didn't work last year. The S&P 500 Growth Index dropped 37 per cent and the S&P 500 Value Index tanked to the tune of 42 per cent.

The average professional manager couldn't even steer away from the rocks. Emerging market, financial services, global small-cap, natural resource, precious metal, U.S. equity, international equity and Canadian equity funds all lost between 30 per cent and 50 per cent.

"This period has acted in a way that has baffled a lot of investment people" says Milton Ezrati, senior economic and market strategist for New Jersey-based Lord Abbett.

Lord Abbett - one of the oldest money management firms in the United States- knows tough times. It opened for business just weeks after the stock market crash of October, 1929. The company survived and thrived on a cautious approach to investing that includes a core diversification strategy. By last March, Lord Abbett managed $106-billion (U.S.) in assets but the broad sell-off slashed that amount by 29 per cent.

That's not too bad considering the S&P 500 was devalued by 39 per cent last year, and it has a lot of investors questioning the religion of diversification.

"To extrapolate this for the long term would be a mistake. We think diversification remains a good play even though it has not worked very well [in 2008]," says Mr. Ezrati.

While Lord Abbett doesn't believe diversification is dead Mr. Ezrati admits it may be in a coma and will eventually revive. "The equity market has discounted a much worse situation than we're likely to see" he says.

Right now Lord Abbett is using cash to position itself for the eventual return of diversification.

Mr. Ezrati expects to get better returns on commodities - like gold, oil and metals - than commodity stocks because the stocks are already priced for higher commodity prices.

"The opportunities lie in commodities and industrials, and less in the consumers," he says.

One money manager who has little faith in equity diversification strategies is Christine Hughes from AGF Management Ltd. "I've never believed that you've got to have something in everything" she says.

Instead she diversifies her $1-billion AGF Canadian Balanced Fund through the three asset classes - a strategic mix of fixed income, equities and cash. Her next consideration is the sectors within the entire portfolio. As an example, she is increasing her natural resource holdings, anticipating a rise in commodity prices, and a resulting rise in the entire resource sector. The actual stocks within the sector are the final consideration.

"Stock selection is the least important. If you get the right sector everything is so much easier," she says.

Flexibility is key to the fund. Its mandate permits as much as 80 per cent in equities or 80 per cent in fixed income at any given time. Normally the asset allocation is capped at 60 per cent either way but anticipating the coming equity market carnage Ms. Hughes reduced her equity weighting to 30 per cent and boosted her fixed-income weighting to 70 per cent.

The fixed-income portion of the fund is almost exclusively Canadian and provincial government bonds. Top holdings in the equity portion include the ProShares Ultra Short S&P 500 ETF, Loblaw Cos. and Goldcorp Inc.

In this case, the strategy has paid off. Over the past 10 years, the AGF Canadian Balanced Fund has consistently outperformed the average Canadian balanced fund and its benchmark index. For 2008 losses have been capped at 9 per cent while the Globe Canadian Equity Balanced Peer Index has declined by 21 per cent.

Ms. Hughes says she will hold the fund's asset allocation at current levels. Her biggest fear is inflation resulting from the onslaught of government stimulus initiatives and drastic cuts in oil supply, so she's adding inflation-adjusted bonds to her fixed income portfolio. "Real-return bonds around the world are trading at the cheapest they've ever traded at," she says.

There won't be many changes on the equity side in 2009. She expects to maintain current positions in commodities, including a gold bullion ETF and gold stocks to combat inflation.

"The real winners will be the hard assets - commodities and energy."

Special to The Globe and Mail