Time to revisit equity diversification strategy?

Equity diversification has fallen out of fashion and investors are missing out on a powerful risk-reduction tool, according to a Capital Group senior manager.

Sunder Ramkumar, who works for the company’s client analytics department and was previously a managing director and portfolio manager at BlackRock, said the philosophy of different equities for different investors predates modern portfolio theory and the capital pricing model by at least 50 years.

He added that now is a good time to revisit the important distinction that “not all stocks are created equal”.

As investors age and go through the different stages of life, so their needs change. Different types of stocks exhibit unique risk and return characteristics that can help offset the changing risks investors face.

Ramkumar said: “Better outcomes can be achieved by harnessing these traits, rather than simply holding the broad equity market and adding more bonds.”

Different money managers slice the market in different ways, be it by yield, market capitalization or valuation, for example. Capital believes the most effective way to distinguish between different stocks is via beta, a measure of their sensitivity to overall market risk, which helps distinguish between cyclical and defensive companies.

Using more than five decades of historical data and breaking the range of beta values into five groups, Capital Group, which has nearly US$2 billion in AUM, found that, unsurprisingly, higher beta stocks are riskier and more volatile but offer higher returns.

However, this was developed further to offer a new perspective when considering how volatility is measured.

Ramkumar explained: “For investors with a shorter time horizon, such as those nearing retirement, defensive lower beta equities have delivered superior results in periods of market stress. This group has produced better downside protection and enhanced returns compared to a mixed stock/bond portfolio.

“This is why we focus on income-oriented stocks in portfolios for investors nearing retirement. These have a more conservative profile that reduce the risk of losses while at the same time keeping a healthy allocation to equities, which offer superior long-term returns compared to bonds.

“Plotting the beta cohorts against their downside capture — a measure of how exposed they are to broad market pullbacks — draws out an important distinction. Traditional measures of risk weigh upside and downside outcomes equally, but sometimes losses hurt more.

“Put simply, low-beta stocks demonstrate less downside and more upside than expected. Compared to simply holding the entire equity market, a portfolio of the most defensive quintile yielded nearly the same average return — but with a more than 40% reduction in downside capture risk. Adding bonds to a portfolio could have lowered downside, but with far lower average returns.”

For younger investors with longer time horizons, such as investors with the stomach to stay the course in the midst of sell-offs, more cyclical, higher beta equities have yielded better outcomes. Capital, therefore, emphasizes growth stocks in portfolios for investors early in the savings cycle

Although more sensitive to volatility in market downturns, high beta stock often bounce back over multi-decade periods.

Ramkumar said: “Equity differentiation strategies have fallen out of favour in an era of passive investing, indexing and market efficiency. This is unfortunate, as the often myopic focus on portfolio diversification has led many to forget that equity diversity can be a powerful risk reduction tool.

“Investors face varied and changeable risks as they age. So why should their equity exposure — often simply an allocation to the S&P/TSX Composite Index or Standard & Poor’s 500 Composite Index via a low-cost index product — remain the same? By viewing the stock market not as a homogenous block but as a mix of individual issues with unique characteristics, better investment outcomes can be achieved.”