Does Diversification Matter Again?

Chief Investment Officer, Model Portfolios

03/10/2022

This article is relevant to financial professionals who are considering offering Model Portfolios to their clients. If you are an individual investor interested in WisdomTree ETF Model Portfolios, please inquire with your financial professional. Not all financial professionals have access to these Model Portfolios.

From the depths of the great financial crisis in March 2009 through the end of 2021, pretty much all you needed in your client’s Model Portfolios were allocations to the S&P 500 Index and the Bloomberg U.S. Aggregate Index, and you were just fine. The S&P 500 (purple line below) outperformed all other major stock indexes except the tech-heavy NASDAQ-100 Index, and interest rates generally fell, providing positive returns in both allocations.

Figure 1and2_SP500and10yrTreasury

The phrase “deworsification” became popular over this period—if you had anything but U.S. stocks and bonds in your portfolio, say for diversification purposes, your performance “worsened.”

We are less than three months into 2022, but already we see a very different picture. Interest rates are up and expected to continue to rise (hurting bond performance), and the S&P 500 Index is falling.

Figure 3_SP500 vs UST

In addition, after more than 10 years of relative “quiescence,” we are beginning to see more volatility in the market (as measured by the VIX, a commonly referenced measure of the volatility of the S&P 500 Index).

Figure 4_CBOE SP500 Volatility

So, rising rates and increased volatility—historically, this has been the market regime in which alternative investments have performed best (or, said differently, the past 10 years of falling rates and low volatility helps to explain why alternative investments have not performed very well). The point is that the inclusion of alternatives may help to improve both the diversification of the portfolio and the consistency of performance.

Fiure 5_JP Morgan BMBG Agg

Another aspect of the current market environment is rising inflation, with recent CPI reports in excess of 6%–7%. Considering this environment, it is helpful to see how different asset classes historically have responded to inflation.

Beta to Expected Inflation of Main Asset Class

Figure 6_Beta to expected inflation

The way to interpret this graph is that, historically, (a) the two best hedges to inflation were U.S. equities and precious metals/miners (highest negative beta to inflation) and (b) broad commodities represented the best way to take advantage of inflation (highest positive beta).

The point of the story is that we believe today’s market environment is ripe for the inclusion of both real assets and alternatives in diversified portfolios, which is exactly what the WisdomTree Endowment Model Portfolios do.

I have been writing about, advocating for and defending the “Endowment Model Portfolio” for more than 10 years.¹ And, periodically, I have had to accept being accused of “deworsification” for doing so. But I still believe it has a place for many investors and advisors— especially now in this period of rising volatility, rising interest rates and uncertain equity market performance.

First, let me define terms. In the actual endowment world, there are no taxes, and time horizons are infinite. Therefore, illiquidity is not an issue. This translates into an Endowment Model Portfolio that holds very few bonds, only enough public equity to make a difference and lots of private and alternative investments, plus real assets.

Of course, in the world of tax-paying, high-net-worth and affluent retail investors who do not have an infinite time horizon, things are different. Does that mean the “Endowment Model Portfolio” doesn’t translate? I don’t believe that is true. Adjusting for the realities of human behavior and taxes, I believe that an appropriate Endowment Model Portfolio for individuals means the following:

Broad and global diversification

Intelligent use of active vs. passive investment strategies (i.e., a cost/benefit optimization of active management fees or, in WisdomTree’s phrase, Modern Alpha^®

A prudent use of nontraditional or less correlated investments in an attempt to improve overall portfolio diversification (i.e., real assets and alternatives)

A long-term time horizon

Investment discipline through full market cycles

We manage five Endowment Model Portfolios (at different risk levels from conservative to aggressive) in exactly this way, and we believe they deserve more attention as long-term solutions for many advisors and end clients. Our most widely used model is the “Moderate Aggressive,” which allocates 50% to global equities, 30% to fixed income and 20% to a combination of alternative and real asset strategies.

Financial advisors who are registered on the WisdomTree website can learn more about them in our Model Adoption Center.

All these Model Portfolios are multi-asset, with allocations to global equities, fixed income, real assets and alternative investments. Somewhat unique, we believe, is our ability to fund the less-traditional asset class positions because we allocate to NTSX, the U.S. version of our “Efficient Core” strategy that takes a leveraged 90/60 position in large-cap U.S. equities and U.S. Treasuries. This provides us with a “core” allocation to stocks and bonds while leaving capital to allocate to other strategies.

On the real asset side, we have allocations to energy master limited partnerships (MLPs), a hybrid real estate/infrastructure strategy, and, via our own GCC, a dynamically managed broad basket of commodities.

On the alternative investment side, we have allocations to a short-biased strategy, a managed futures strategy (via our own WTMF and a hedged equity strategy in the form of our own put-writing strategy, PUTW.

The explicit purpose of these Model Portfolios is to seek to deliver consistent, absolute return performance, regardless of underlying market conditions. To date, they have performed as expected. They will not keep up with a raging bull equity market, but they are designed to not lose as much in down or disruptive markets. And, historically, that’s what they’ve delivered (using the Moderately Aggressive model as an example).²

Figure 7_WT Endowment Model

For standardized performance of the underlying Funds, please click here.

In addition to our Endowment Model Portfolios, we also offer a Volatility Management Model Portfolio. This is one of our “outcome-focused” Model Portfolios designed with explicit investment objectives in mind. In this case, to be used as a complement to existing more-traditional Model Portfolios when the advisor and/or end client wants a more “endowment-like” portfolio experience.

In addition to the short-biased, hedged equity and managed futures strategies that are embedded in our Endowment Model Portfolios, the “Vol Man” Model Portfolio also has explicit allocations to diversified arbitrage³ and a different form of hedged equity.⁴

Similar to the Endowment Model Portfolios, our Vol Man Model Portfolio has performed as it was designed to do.⁵

WisdomTree Volatility Management Model Portfolio

Figure 8_WT Volatility Model Portfolio copy

For standardized performance of the underlying Funds, please click here.

As with all WisdomTree Model Portfolios, our Endowment and Volatility Management Model Portfolios share certain common characteristics:

They are global in nature
They are ETF-centric to optimize fees and taxes
They are “open architecture” and include both WisdomTree and third-party strategies
They charge no strategist fee

Conclusions

With market conditions where they are, we definitely are receiving more questions from advisors about less-traditional and/or more-diversifying Model Portfolio solutions.

We think the Endowment Model Portfolios and the Volatility Management Model Portfolio can be appropriate solutions to those questions.

We hope you will take a look.

¹Scott Welch, “In Defense of the Endowment Model,”, IMCA Investments & Wealth Monitor, May-June 2010, pgs. 32-–2636. (https://investmentsandwealth.org/getattachment/75a77ec3-2a97-44f7-bae8-196e6c52b895/IWM10MayJun-EndowmentModel.pdf).
²Past performance is no guarantee of future results.
³A “diversified arbitrage” strategy is one that employs multiple types of investment strategies that seek to profit from corporate capital- raising events such as new debt, equity, and convertible issues and corporate control events such as mergers or bankruptcies.
⁴“Hedged Equity” refers to an investment strategy that maintains both long and short equity securities positions, in an attempt to capture up market movement via the long strategies while mitigating down market movements via the short positions.
⁵Past performance is no guarantee of future results.

Important Risks Related to this Article

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