From the blog: Over the past five years, diversified growth funds have generally performed well. In fact, all three median DGF series compiled by Camradata met or exceeded their return targets from January 2012 through December 2016.
However, this success appears to have been largely driven by strong stock and bond market returns.
The broad DGF universe has been highly correlated (often as high as 0.9) with a currency-hedged traditional global 50 per cent stock, 50 per cent bond portfolio.
However, this success appears to have been largely driven by strong stock and bond market returns. The broad DGF universe has been highly correlated (often as high as 0.9) with a currency-hedged traditional global 50 per cent stock, 50 per cent bond portfolio.
For instance, during the 20 quarters from 2012 through 2016, DGF and global 50/50 returns always had the same sign — when global 50/50 was up, DGFs were up, and when global 50/50 was down, DGFs were down.
Unless DGF managers change their strategies to be less correlated with traditional portfolios, they may be unlikely to match recent performance
Due to this correlation, the average DGF has benefited significantly from the unusually good performance of global 50/50 during the same period.
From 2012 through 2016, a period of benign macroeconomic conditions, global 50/50 delivered a 1.5 Sharpe ratio, well above the 0.4 Sharpe we expect for it over the long term.
No extra outperformance
After accounting for its exposure to global 50/50, the median DGF series has not provided any additional returns (ie zero or negative annualised alpha).
In other words, the typical DGF’s high returns from 2012 through 2016 have been driven by the same market exposure already pervasive in investors’ portfolios.
With valuations of stocks and bonds currently elevated by historical standards, investors would be well advised not to rely so heavily on these assets to drive performance in the future.
Generating sustainable total returns with less reliance on rising prices for traditional assets requires investing in a more diversified set of risk premia than the typical DGF does.
DGFs and global 50/50 are highly correlated because both have the lion’s share of their risk in stocks. Since stocks are much riskier than bonds, even a balanced capital allocation like 50/50 may lead to equity risk concentration.
Better diversification
We believe in allocating to a broader set of market risk premia, active alternative risk premia with low correlations to markets, and differentiated sources of alpha.
Our confidence in the existence and persistence of this broad array of return drivers stems from economic intuition, financial theory, and ample empirical evidence across different time periods, regions, and asset classes.
This approach derives most of its expected return from sources other than equity market beta.
It should therefore be less dependent on the macroeconomic environment, and about as likely to perform well in good market environments as during times that are less favorable for stocks, such as low growth and inflationary periods.
DGF managers take heed
Looking ahead, it is unlikely the next five years will be as favourable for traditional stock/bond portfolios as the past five years have been.
Therefore, unless DGF managers change their strategies to be less correlated with traditional portfolios, they may be unlikely to match recent performance.
We strongly believe aggressive diversification across a broad range of intuitive, empirically tested return sources is a better approach over the long run.
John Huss is portfolio manager at AQR Capital Management.
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