Why the hidden equity qualities in non-equity (stocks) assets has neutered the risk reduction value of diversifying a protfolio...

1. Joel Framson & Eric
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The Myth of Diversification
To Our Friends of Silver Oak,
We are pleased to once again share with you our quarterly letter to Clients, as a friend
of Silver Oak Wealth Advisors. If there are those recipients who do not wish to receive
our markets and economic thoughts and observations, please let us know and we will
“unsubscribe” you immediately. By the same token, if you know someone you believe
would enjoy being on our distribution list, let us know as well, and we will gladly add
them. Now, to the topic…
While we would truly like to claim the topic of this quarterly letter as
our own, we are neither bold enough to dismiss diversification as a
myth nor creative enough to have coined the phrase. However, since
we were sufficiently impressed by the concept, we have received
approval from PIMCO to utilize their phrase and some insights from a
recent PIMCO Viewpoints article. Their article was posted on the
PIMCO website in September.
In short, their primary point can be summarized in one sentence,
“Diversification often disappears when you need it most.”
When markets are rising smoothly, when the economy is growing at a
good pace, and when inflation is under control, diversification is
important. But it is precisely when the economy is struggling, when
inflation is either nonexistent or rampant, and when markets are in
disarray that we need diversification to work. Unfortunately, as we
have seen over the past two years, diversification has failed the
investor.
To be effective, diversification should smooth out portfolio returns. Its
function is to reduce portfolio risk by reducing volatility. The goal is to
build portfolios with sufficient types of investments, or asset classes,
that can be expected to move in somewhat different directions under

2. different market conditions.
But as PIMCO pointed out, we may not be able to continue counting on
traditional asset classes to move in opposite directions. Consider U.S.
and foreign developed countries stock markets. From January 1970 to
February 2008 both markets performed quite well, albeit during
alternating cycles. In fact, the pattern of returns (correlation) of those
two stock markets was negative, indicating that when one market rose
the other tended to fall, and vice versa. However, during times when
both markets declined significantly, the correlation between them was
+76%. Such asymmetrical result causes us to be wary that the
traditional patterns of returns between asset classes may not be
reliable.
PIMCO also points out that in this period which they have dubbed the
New Normal, markets seem to be oscillating between two levels of risk
– either totally “risk on,” or totally “risk off”. In other words, some of
the extreme price swings can be attributed to market factions deciding
that they want to load up the cart with risky assets, then abruptly dump
the contents of the cart when they decide that they want no risk. The
electronic trading platforms and short sellers are good examples of
these factions, and they play a dominant role in moving the market.
Here is another great quote from PIMCO. “In such a world
diversification across asset classes might work on average, but it might
feel like having your head in the oven and your feet in a tub of ice: Even
though your average body temperature is OK, your chances of survival
are low.”
Risk Factor Diversification vs. Asset Class Diversification
As we said earlier, diversification is a good tool and we don’t want to
throw out the baby with the bath water. The question becomes how
do we improve on traditional asset class diversification?
At Silver Oak, we often speak about a building block approach to
portfolio construction. We believe that risk factors, as opposed to asset
classes, are the appropriate building blocks to use. PIMCO conducted a
study that tracked market movements over the last fifteen years based
on both risk factors and asset classes which corroborated that
controlling the risk factors produced more acceptable correlations
during both quiet and turbulent market conditions. In other words,
diversification actually worked through controlling risk factors versus
the traditional approach using asset classes.

3. One explanation for this is that many asset classes contain indirect
exposure to equity risk. As PIMCO points out, “To complicate things,
indirect equity risk is like a virus that remains dormant until the body
weakens: It tends to manifest itself during extreme market moves.” We
have seen a number of extreme market moves since the year 2000,
with some quite significant events in just the last two years. Without
proper risk factor diversification, investors discovered that too many of
their supposedly diversified asset classes performed like risk assets,
falling simultaneously.
As Silver Oak modified our approach back in 2008 in recognition of this
concept, we coined the terms “Higher Risk Bucket” and “Lower Risk
Bucket” to help us explain this concept to our clients. We observed
that during the recent financial crisis, asset class correlations and
volatility across asset classes changed drastically, and seemingly
diversified portfolios performed poorly. Once we began to build
portfolios using risk factors as the building blocks, we were better able
to create the desired effect of diversification – lowering overall
volatility.
Market Summary
The U.S. and global equity markets experienced strong gains during the
recently ended third quarter. The S&P 500, for example, is depicted in
the chart below.
While it appears like a strong Q3 for the S&P 500, and in fact it did rise
by 11.3%, this index is only positive 3.9% for the first nine months of
2010. With the high levels of volatility demonstrated in the chart, we
continue to focus on the reality that this is much too much risk for the
amount of return.
In fact, we can look back over the past three years ending on
September 30th
and find a similar pattern. Over those three years, the
S&P has lost 7.1%.

4. We now have three quarters of the year behind us. As we suspected,
there were bold headlines and numerous global financial challenges
impacting the markets during those nine months. Unemployment is
still at 9.6% and the government is talking about yet another stimulus
package. On top of those factors, this is an election year. The results of
the November election can be expected to have major implications for
income taxes, estate taxes, and government financial programs.
We find ourselves in the midst of a bull rally now, yet uncertainty
abounds. Bullish investor sentiment has steadily risen; bearish
sentiment has fallen to 22%. Economic indicators are improving, BUT
macroeconomic data showed that GDP contracted 0.6% in August.
Which begs the question, who is doing the buying that is fueling this
rally? The retail investor has been selling into this entire bear market
rally and rebalancing portfolios in favor of income. The principal buyers
right now, postulates David Rosenberg of Gluskin Sheff, are the pension
funds, hedge funds, and the proprietary trading desks at the big banks.
That is not money that is circulating into the economy to fuel economic
growth. And until there are signs that the consumer will start spending,
we will continue to keep the bulk of our powder dry.
That said, as we look ahead, we anticipate continuing to exceed our
expectations for our annual portfolio returns, with far less risk than the
market. Of course, as Casey Stengel said, “it ain’t over ‘till it’s over.”
Nevertheless, as we look at portfolio returns through the third quarter,
we feel very good about where things are. With some minor portfolio

5. changes that we made at the end of September, we believe that the
portfolio building blocks that we need to accomplish our objectives are
in place for the next quarter.
As always, we welcome your questions and comments.
Sincerely,
Joel H. Framson, CPA/PFS, CFP® Eric Bruck, CFP®
President Principal