Diversification of investment portfolios across different asset classes is less effective than most investors think, because the implementation of the strategy often leaves little to be desired.
"Diversification is often claimed to be the only free lunch in finance. I can tell you that is rubbish, largely because of the way people think about diversification," GMO asset allocation team member James Montier said.
Montier said one of the main problems with diversifying into a new asset class is that investors often do it after valuations have gone up significantly.
"Diversification was often done in a returns chasing fashion. In exactly the same way we tend to laugh at individual investors who chased tech stocks in 1999, professional investors do the same thing," Montier said.
"If you look at the inflows into US private equity partnerships, something like 95 per cent of the inflows have occurred since 2003. They charge in when the returns are being good. Strangely enough, when you charge in and flood an asset class with money, what happens is that deals get done at higher prices.
"What happens when you drive up the price? Well, unsurprisingly, you drive down the return."
Montier said that since investors have flocked to private equity, returns have been poor.
"In fact, you would have been better off putting your money in public equity rather than private equity, because these things had twice the leverage and generated a return that was roughly in line with the S&P 500. That is an appalling performance," he said.
Investors are also not always examining the true levels of correlation when they diversify into a new asset class.
"Diversification was done in name only," Montier said.
Hedge funds have been a popular choice in diversification strategies, but Montier said most of these funds do more or less the same thing.
"The correlation between hedge funds has been rising steadily. In the early 1990s, it was somewhere about 0.3 to 0.4. I'm talking about funds ranging from arbitrage, global macro to emerging market debt. There should be very little correlation. Yet, today what we find is that correlation stands at somewhere over 0.8," he said.
"All of these hedge funds are doing exactly the same thing, and what they are doing is effectively selling volatility or riding momentum. So you are getting absolutely no diversification," he said.
