Great ‘Bear Market’ in Diversification: Only 1 of 370 Funds Beat S&P 500

Key Takeaway

• Diversified portfolios have underperformed the S&P 500 in 13 of the last 15 years, with only one out of 370 asset-allocation funds beating the index since 2009.
• The S&P 500's annual gain of 14% since the financial crisis has significantly outpaced international stocks and bonds, leading to skepticism about diversification.
• Elevated Treasury yields and concentration risks in tech megacaps like Nvidia highlight ongoing challenges for diversified strategies amidst a prolonged US stock rally.

Diversification Under Scrutiny

Investors who adhered to the traditional wisdom of diversification are finding themselves lagging behind the US stock market's impressive rally. According to Morningstar Inc., out of approximately 370 asset-allocation funds, only one has managed to outperform the S&P 500 since 2009. Diversified portfolios have returned around 6% annually, based on a model by Cambria Funds, but they have trailed the US large-cap stock index in 13 of the last 15 years. This underperformance is becoming historic, with the AI-driven equity surge exacerbating the trend.

Meb Faber, founder of Cambria and a portfolio-theory expert, describes the last 15 years as a "bear market in diversification." His $54 million Cambria Global Asset Allocation ETF has underperformed the S&P 500 every year except one since its inception, despite an annualized 5% gain. The psychological toll on investors, both small and large, is significant, as they watch US stocks, particularly tech giants like Nvidia and the "Magnificent Seven" (Alphabet, Amazon, Apple, Meta, Microsoft, and Tesla), dominate the market.

The Case for Diversification

Despite the allure of US stocks, diversification remains a crucial strategy for many investors. Institutions such as pensions, endowments, and foundations have $21 trillion invested in diversified strategies, according to a study by Preqin. David Kelly, chief global strategist at J.P. Morgan Asset Management, likens diversification to home insurance: "You never know when you’re going to need it, but you should never feel comfortable not having it."

Financial advisers like Anthony Syracuse of Dynamic Financial Planning often find themselves restraining clients eager to chase the Big Tech rally. "This can be an extremely difficult conversation," Syracuse said. "Everyone wants to maximize their returns." The S&P 500 has outpaced almost everything since the global financial crisis, with a 14% annual gain, double that of developing country stocks and three times that of investment-grade bonds.

Fixed Income and Alternative Assets

The reliability of fixed income as a hedge has come into question, especially after bonds sank alongside stocks during the inflation-induced selloff of 2022. David Rogal, a portfolio manager at BlackRock Inc., noted, "It’s very clear that the bond market has become less reliable as a hedge in a portfolio." Inflation is expected to remain sticky, making bonds vulnerable as the government increases Treasury supply to meet fiscal needs.

In response, some investors are turning to alternative assets. Big-money managers are increasingly shifting to privately held firms to boost performance. Meb Faber of Cambria observed, "Institutions have been leaning hard into this, but the savior that they’re looking for is private equity, which is essentially US stocks."

Street Views

• Meb Faber, Cambria (Bearish on diversification):

  "If your neighbor has all their money in the S&P, then you look like a moron."

• Anthony Syracuse, Dynamic Financial Planning (Neutral on diversified portfolios):

  "This can be an extremely difficult conversation. Everyone wants to maximize their returns."

• David Kelly, J.P. Morgan Asset Management (Cautiously Optimistic on diversification):

  "Diversification is your best friend on your worst day... 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."

• Mayukh Poddar, Altfest Personal Wealth Management (Neutral on diversification):

  "The question everyone has is, does it make sense to diversify? A lot of people have become more focused on equity market returns in the post-Covid era."

• Que Nguyen, Research Affiliates (Bearish on small-cap and non-US stocks within diversified portfolios):

  "What we’ve seen over the last 15 years is that the big gets bigger. You don’t want all of your eggs in one basket, but it’s hard to keep the faith."

• David Rogal, BlackRock Inc. (Bearish on bonds as a hedge):

  "It’s very clear that the bond market has become less reliable as a hedge in a portfolio."