In this second e-book, I examine the vicissitudes of diversification in the ever more global capital marketplace, in which correlations trend closer and closer to 1.0. The headlong rush of pension plans, endowments, and wealth management assets into hedge funds, private equity, commodities, and private real estate provides a lens to observe just what transpires when, as almost always occurs with initially good ideas, Wall Street runs it into the ground.
One of the grimmest realities of finance is that as an asset class becomes more popular, it suffers the twin plagues of falling expected returns and rising correlations. While this booklet offers useful guidance to small investors, its real audience is in the institutional realm, which, without putting too fine a point on it, is headed en masse off a cliff called "The Yale Model."
This booklet explores the notion that, as a general rule, no magic policy rich in high return/low-correlation alternative asset classes exists that will simultaneously preserve upside reward and protect against downside losses. And as long as I’m lowering your expectations, this booklet is most certainly not a blueprint for the “perfect portfolio.” You’re an adult, after all, so you know that the future efficient frontier lies well beyond our ken; presumably you already know all about the mechanics, long-term benefits, as well as the uncertainties, of wide diversification and factor tilt using low-cost, efficient vehicles and the risk/reward spectrum between all-fixed-income and all-equity portfolios.
