They did everything right — spreading out bets far and wide across bonds and equities in case things went south. Now, after heeding Wall Street’s mantra to diversify for the long haul, these investors are watching with envy as the US stock rally leaves them in the dust yet again.
The numbers are stark. Money managers who obeyed the financial industry’s age-old wisdom to divide investments across markets and geographies are on an epic losing streak versus those who simply bought the S&P 500 and sat still. In one example, out of roughly 370 asset-allocation funds tracked by Morningstar Inc., just one has managed to beat the index since 2009.
It’s been a big lesson in futility, rather than a disaster per se. Diversified portfolios have still managed to return around 6% a year over the stretch, going by a model kept by Cambria Funds. Yet the streak of underperformance is getting historic — and could get worse as the AI-fueled equity melt-up endures. Broadly, diversified portfolios have trailed the US large-cap stock index in 13 of the last 15 years, a stretch seen only once before in almost a century of data, per Cambria.
“If your neighbor has all their money in the S&P, then you look like a moron,” said Meb Faber, the founder of investment firm Cambria and a portfolio-theory expert.
For small-fry investors and big money managers alike, the psychological toll of falling behind creates pressure, particularly for those sticking with the playbook. Institutions from pensions to endowments and foundations have $21 trillion stashed in conventional diversified strategies that spread money across a wide range of investments including bonds, stocks, real estate and cash, a recent study by Preqin showed.
Yes, betting the house on US stocks looks dangerous as Nvidia Corp. and other technology megacaps dominate the world’s largest equity market, posing an unprecedented concentration risk. At the same time, elevated Treasury yields offer a potential buffer if stocks stage a big crash. And yet, adherents of diversification are plagued with doubt. US shares remain the only game in town year after year, thanks to Corporate America’s reliable profit engine. Owning anything else has been a route to underperformance.
Faber calls the last 15 years a “bear market in diversification.” His $54 million Cambria Global Asset Allocation ETF (ticker GAA) has trailed the S&P 500 in all but one year since its inception despite an annualized 5% gain.
While history has instances of similar drubbings that resolved in favor of diversification, the wait has been a particularly long one this time around.
These days, financial advisers like Anthony Syracuse often find themselves having to restrain clients eager to chase the Big Tech rally given the juiced-up valuations versus the rest of the market.
“This can be an extremely difficult conversation,” said Syracuse, founder of Dynamic Financial Planning. “Everyone wants to maximize their returns.”
American stocks have been on a blistering run since the global financial crisis, outpacing almost everything in a period when bond returns were suppressed during the zero-rate era while international stocks languished under the weight of a strong dollar. Up 14% annually, the S&P 500’s gain is double that of stocks in developing countries and adds up to three times as large as investment-grade bonds.
Against this backdrop, nearly everyone straying from US equities is subject to a sense of missing out. Over the last 15 years, the PIMCO StocksPLUS Long Duration Fund (PSLDX) is the one and only among the 372 asset allocation portfolios tracked by Morningstar that’s ahead of the S&P 500.
The data has emboldened those who say diversification — however sound in theory — is costing investors over the long run, by holding underperforming investments. The revolt got an airing last year when academics published a study saying retirees would be better off eschewing bonds completely.
Proponents of modern-day allocations pushed back, saying assets like fixed income allow individual investors to better match financial gains with future obligations. Moreover, diversified portfolios won out from 2000 to 2008, a period when stocks saw their values cut in half on two separate occasions.
“Diversification is your best friend on your worst day,” said David Kelly, chief global strategist at J.P. Morgan Asset Management. “The right asset allocation is a little bit like home insurance. You never know when you’re going to need it, but you should never feel comfortable not having it.”
That logic is partly what’s behind the decision by many big-money pros, who periodically shuffle holdings in order to return to a desired level of asset allocation.
Of course, pure returns are not the only thing that matters. Another consideration is how much turbulence must be endured in order to earn the profit. Based on a measure of risk-adjusted returns known as the Sharpe ratio, Cambria’s global asset allocation model has indeed done better than the S&P 500 since 1927.
But things started to shift after the Federal Reserve rushed to the market’s rescue during the 2008 crisis. Since then, the S&P 500 has staged an almost uninterrupted rally with largely subdued volatility, scoring a higher Sharpe ratio.
“The question everyone has is, does it make sense to diversify?” said Mayukh Poddar, senior portfolio manager at Altfest Personal Wealth Management. “A lot of people have become more focused on equity market returns in the post-Covid era.”
Within diversified portfolios, many clients are growing skeptical over the benefit of investing in small-cap and non-US stocks, according to Que Nguyen, chief investment officer of equity strategies at Research Affiliates.
“What we’ve seen over the last 15 years is that the big gets bigger,” she said. “You don’t want all of your eggs in one basket, but it’s hard to keep the faith.”
In some circles, fixed income’s haven status is questioned too, after the asset class sank together with stocks during 2022’s inflation-induced selloff.
Inflation is likely to stay sticky, making bonds exposed at a time when the government ramps up Treasury supply to meet fiscal needs, according to David Rogal, a portfolio manager at BlackRock Inc.
“It’s very clear that the bond market has become less reliable as a hedge in a portfolio,” Rogal said in a recent panel discussion hosted by MacroMinds Foundation.
It’s tempting to call an end to the equity rally, given the prospect of stretched valuations and restrictive monetary policy. Yet the S&P 500 has kept its leadership this year, delivering a gain that’s again ahead of the rest of the world and contrasts with losses in Treasuries.
There are signs that American investors are adapting to the new regime, including a deepening home bias and a willingness to let equity holdings swell to records, according to Cambria’s Faber. Meanwhile, big-money managers are shifting to alternative assets such as privately held firms as a way to juice up performance.
“There’s no end-expiration date on this” equity boom, Faber said. “Institutions have been leaning hard into this, but the savior that they’re looking for is private equity, which is essentially US stocks.”
