“It is the part of a wise man to keep himself today
for tomorrow, and not venture all his eggs in one basket.” – Sancho Panza

Don Quixote, by Miguel de Cervantes [1547-1616]

Diversification may well be the oldest risk-management strategy in the world and is certainly the most widely advocated investment approach. While it is overwhelmingly supported by most investment theorists, one can still find a few detractors.

Warren Buffett has jokingly said “Diversification is protection against ignorance. It makes little sense if you know what you are doing.” But for many investors, advisors, and fund managers who freely admit that they do not know where the market will be next month, let alone next year, diversification creates a wider range of opportunities for profit, minimizes exposure to risk in any one area, and ideally reduces volatility in the portfolio.

Active investment strategies—which strive to adapt to market conditions while limiting portfolio risk—do not need to rely solely on the static diversification among asset classes common to passive allocations. But diversification still plays a strong role in the actively managed portfolio. The difference is that active managers are also increasingly diversifying by strategies and managers.

Why not adapt the allocation to take advantage of opportunities that the current market environment offers?

In a traditional passive portfolio, one typically sets an allocation of stocks and bonds with the expectation that when the equities allocation underperforms, bond performance will compensate. The equity and bond portions of the portfolio are also diversified to offset the potential of underperformance in one area with higher quality returns in another. For example, a bond portfolio may be diversified among government, corporate, and high-yield bonds. The vulnerability of this approach is that part of the portfolio is usually underperforming, reducing overall returns.

Among the questions investors inevitably ask is, “why are we investing in underperforming assets?” Why not adapt the allocation to take advantage of opportunities that the current market environment offers?

Diversification takes this a step further to acknowledge that there are many different ways to actively invest, some of which perform better in different market conditions than others. While active investment strategies strive to adapt to market conditions, no investment strategy consistently outperforms the market every quarter, or even every year. Every investment strategy has stopped working—or delivered less-than-optimal results—at some point. An advisor may have faith in his or her chosen approach and be willing to hold on until it rebounds, but the average client is often another matter.

Diversifying by investment strategy as well as by investment manager allows portfolio volatility to be reduced, ideally improving performance over the long run.

In or out diversified allocation strategies

Many active management firms began by allocating portfolios between stock, bond, and money-market mutual funds, adjusting the mix based on the market’s direction. It made sense. Mutual fund exchanges could be made within the same fund family (and later the fund platform) at no cost. Investors benefited from the investment selection abilities and diversification provided by the mutual fund, with the added layer of risk management.

The campaign against “market timing” and resulting limitations on the number of permitted exchanges by the fund families adversely affected many third-party managers using this approach. But new investment vehicles emerged in the form of index funds, exchange-traded funds (ETFs), stock baskets, and cost-effective access to individual securities that launched a much wider and more diverse active management universe. Typically, today’s allocation strategies focus on market indexes, such as the S&P 500 or NASDAQ, and adjust allocations in response to changes in the index’s trend. These strategies may also use leveraged and inverse funds to enhance opportunities for profit.

Diversifying by investment strategy as well as by investment manager allows portfolio volatility to be reduced.

Equity strategies

Equity strategies have proliferated with the development of index, sector, and country funds, and the ability to trade individual securities relatively inexpensively, along with advances in technology and the availability of market data. Equity approaches typically strive to identify leading investments within a defined universe or segment of the market. Among the equity investment approaches are strategies such as market leaders, sector rotation, and country leaders. While these strategies may retreat to the safety of money markets in extreme market conditions, noncorrelated investment vehicles typically exist to keep strategies invested.

Bond strategies

Bonds are an entire investment universe in and of themselves. Domestic U.S.Treasury, government agency, municipal, corporate, and corporate high-yield issues compete with international government and corporate issues. Managed funds, index funds, and individual securities all offer opportunities to exploit trends and market inefficiencies for profit. The result has been manager and strategy specialization focused on the bond markets that often use both long and short positions.

Absolute-return strategies

Absolute-return portfolios are designed to produce a positive return regardless of the direction and the fluctuations of capital markets. How the third-party manager arrives at that return can be a blend of noncorrelated investments or more esoteric, proprietary investment approaches or hedges. Absolute-return strategies are not designed to outperform market indexes but seek to always increase value in the portfolio.

Alternative investments allocation

Alternative investment strategies take the technical analysis expertise of active management and apply it to assets beyond traditional stocks, bonds, and cash. These assets may be private equity, options, futures, commodities, leveraged funds, hedge funds, exchange funds, real estate, structured notes, and so on. Manager and strategy specialization become part of the diversification mix.

Hedge funds

Hedge funds may be part of the alternative strategy mix or their own allocation with the caveat that they are restricted to qualified investors and usually have holding period requirements. While there is a tendency to characterize hedge funds as long-short strategies, their current field is much broader. Hedge funds are currently less regulated by the U.S. Securities and Exchange Commission (SEC) and, being relatively less restricted, can invest in a wider range of securities than mutual funds. That leaves a lot of room for different approaches to the market.

Adding depth and responsiveness to diversification

Within each of these diversification opportunities, active managers may be using a variety of technical approaches to determine their view of the market, including fundamental analysis, trend following, pattern recognition, relative strength, momentum, mean reversion, seasonality, market cycles, and more. While actively managed strategies are often disciplined, mathematical approaches to investing, they have the flexibility and maneuverability that is lacking in traditional buy-and-hold portfolios.

The result is a fascinating blend of opportunity. Add the ability to go long, short, or to cash and to use leveraged vehicles, and investing enters a new dimension that is no longer dependent on a rising market for profitability. At times, the choices may seem overwhelming, but the diversity of an active management approach also highlights the vitality and excitement of this rapidly expanding investment discipline.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.