You know the benefits of diversification. If you look closer, however, there are two kinds of diversification. Each is different in its objective, in its execution, and in how it is measured.
- Rainy Day diversification: There could, one day, be a global economic collapse similar to the Great Depression. For those who want to prepare for that possibility, it is rational to have some percent of your assets in essentially risk-free (meaning, disaster-immune) investments such as cash equivalents. An alternative would be to design a hedge with derivatives. Both strategies could prove to be expensive, because they also limit your upside, in some cases substantially.
- Performance Smoothing: This is diversification among high performing investments that are uncorrelated with each other. This means that when one is in a slump – as all high performing instruments sometimes are – another of your high performing investments will be performing well. The benefits of combining uncorrelated high performing investments are that your overall returns will remain high – this isn't rainy day diversification – but the results will be smoothed out. The drawdowns should be lower than for any one of the investments individually.
Examples of performance smoothing diversification are:
- Sector level: Invest in sectors of the market that respond differently to market conditions.
- Type of investments: A high performing private equity fund and a high performing commodities and currency hedge fund might make a great addition to a high performing equity fund. Neither will water down the risks of the other, but together they are likely to smooth out your earnings.
- Diversification of Sovereign Risk: Another powerful strategy is to place your investments in different national economies.
To demonstrate the benefits of diversifying your sovereign risk (different countries) as an example, take a look at what happens to your returns and drawdowns if you were to invest in both our Canadian and US Equity Funds.
| US Market | Canadian Market | 50-50 Portfolio | |||
| Horizon | 12/31/1998 – 12/31/2006 | 6/30/1990 – 12/31/2006 | 12/31/1998 – 12/31/2006 | ||
| Martial Capital US Equity Fund | S&P 500 | Martial Capital Canadian Equity Fund | TSX Composite | Equal dollars into each Martial Capital fund | |
| Compound Annual Growth Rate (CAGR) | 44.81% | 1.76% | 29.61% | 10.52% | 40.14% |
| Worst drawdown | -19.34% | -46.34% | -17.78% | -43.32% | -11.53% |
| Worst 3 month drawdown | -17.56% | -18.52% | -17.78% | -26.89% | -10.25% |
| Worst 6 month drawdown | -9.66% | -29.03% | -12.73% | -27.72% | -7.06% |
| Worst 12 month drawdown | +0.72% | -27.35% | -8.94% | -33.17% | -3.22% |
The benefits are clear. The returns remain high, but the drawdowns are significantly reduced compared to investing in either of our funds alone.
Notes:
- These data come from our backtest period. This is not as strong a demonstration as if these data came from a period of live trading.
- Markets are unpredictable. It is almost certain that one day the markets will have a particularly vicious drawdown and we will break these records with a worse drawdown. It will happen one day; the only question is when.
- The returns for the two indices are before any fees. In reality, if you were to buy an Index Fund based on either index, there would be administrative fees. With the S&P 500 earning 1.76% per year over the last 8 years, a significant portion of the potential returns would have been taken away by the fund administrator. The returns for our funds are after a 2% of assets annual fee plus profit sharing equal to 20% of profits (high water mark method). Expenses (trading commissions, for example) have not been deducted from any of these numbers.
- The maximum drawdown number for the TSX in this chart is different from the worst drawdown number in the chart on the page "What is a Drawdown?" This page is based on month-end data, the chart on "What is a Drawdown?" is based on daily data.
- There is no guarantee we will always be able to achieve our backtested results during live trading.
All performance data contained on this site represents past performance. Past performance is no guarantee of future results. These funds are subject to the risks relating to investing in the stock market. These risks include the possibility that stocks may experience large price swings with the potential for significant loss of your investment.
