“Don’t put all your eggs in one basket” is an investment adage that dates back to the beginning of civilization. It means dividing your assets among different investment types to help protect your principal from a large loss when one basket fails.
Diversification among asset classes is a hedge. A well-constructed portfolio reduces risk and increases return in the long-term. The question is: How do you choose the right baskets?
A well-chosen asset class offers both risk diversification and real return potential. Not all asset classes fit these two criteria. Some are unique but have returns no higher than the inflation rate. Others offer a real return but provide little risk diversification. Still others provide diversification and a real return benefit but are inaccessible or too expensive to invest in. The challenge is to find asset classes that offer a real return, risk reduction, and are accessible in a diversified and low-cost investment product.
Over the years, I developed three tests for asset class selection. An asset class must pass all three tests to be included in a portfolio. A “No” answer on any test disqualifies an asset class:
- Does an asset class provide exposure to a unique investment risk?
- Does the asset class provide a real return (higher than the inflation rate)?
- Is the asset class available in a broadly diversified, liquid, low-cost fund?
Does an asset class provide exposure to a unique risk?
At its core, diversification is a hedge against too much risk in one basket. In order to have risk diversification, investments in a portfolio must be fundamentally different from one another. Sometimes the fundamental difference between investments is obvious. Corporate stocks are uniquely different from government bonds. Stocks represent ownership and share in business profit and loss. Bonds are obligations of the government and a fixed interest rate is regularly paid to the bond holders. The unique risk in owning stock is that the company may not be profitable. The unique risk in government bonds is unexpected inflation.
Often unique risk can be found in a subset of an asset class. Real estate investment trusts (REITs) are a unique asset class. They represent underlying rent collected from collateralized commercial real estate. REITs pay no corporate index taxes providing 90 percent of the free cash flow is passed on to shareholders.
The figure below highlights the 3-year annualized return difference between the Russell 3000 and the Dow Jones Select REIT index. It will help you visualize the large difference in return that can occur between REITs and the rest of the stock market.
A rolling correlation analysis helps verify the unique risk in REITs. The nest figure below illustrates the rolling 36-month correlation between the Russell 3000 index of US stocks and the Dow Jones Select REIT index of commercial property.
At times, there is substantial variability in the rolling 36-month correlation between REITs and the rest of the market. This illustrates the unique risk in REITs. Unique risk can be overshadowed by larger market-wide risk, and this will cause the correlation to be high during those times. However, it’s the variability in rolling correlation that’s the most important part of this analysis. A varying correlation signals a unique asset class risk that will provide diversification benefit at times.
Does the asset class provide a real return (higher than the inflation rate)?
All asset classes held in a portfolio long-term must independently earn a return that is greater than the inflation rate. Stock prices have an inflation expectation built-in and also grow above inflation as real earnings growth occurs and dividends are paid by the companies. Bonds pay interest based on the expected inflation rate until maturity, plus a fair risk premium over inflation based on the riskiness of the bond.
An investment not meeting the real return criteria is not suitable for inclusion in a long-term portfolio. Commodities and precious metals are good examples. These currently popular investments tend to have low correlation with stocks and bonds at times and thus, have unique risk. However, in the long-term, this risk is not compensated for.
The returns from commodities and precious metals equal the inflation rate at best. This disqualifies commodities and commodities futures products as investments in a long-term portfolio. These investments may be suitable for traders who try to make money by speculating on short-term price movements, but they’re not suitable for long-term investors.
Is the asset class available in a broadly diversified, liquid, low-cost fund?
Asset classes with unique risk and a real return must be easy to invest in to be included in a portfolio. Mutual funds that have low expense ratios and no redemption fees are good choices. Particularly attractive are index funds and exchange-traded funds (ETFs) that track broad asset classes because they typically have low-fees, track the asset class well, and can be easily traded.
The fund selected to represent an asset class should provide enough diversification internally to adequately represent the risk in the asset class. Broad diversification within a fund ensures that the tracking between the investment vehicle and the asset-class category is high.
Some asset classes are only available in an expensive packaged product. These are not well-suited for a portfolio. These investments are typically formed through an expensive, illiquid limited partnership (LP). They include hedge funds, commodity trading funds, private equity funds, venture capital funds, and fund-of-fund products.
There are also asset classes that have no simple investment means. Museum-quality oil paintings by Old Masters are a fine example. This asset class has unique risk and a real return, however, there’s no easy way to buy Old Masters. Consequently, it doesn’t matter how attractive an asset class seems, your time is better spent investigating asset classes that are investable.
In summary, a potential asset class for a well-diversified portfolio should pass three criteria. First, offer exposure to a unique investment risk. Second, have a positive inflation-adjusted return. Third, be available in a diversified, low-cost fund that has liquidity. A diversified portfolio built on asset classes that pass these three tests will provide you with both a real return benefit and a risk reduction benefit — and do so with full liquidity and low cost.