Investment strategies can be broken down into two broad categories: convergent and divergent. Convergent strategies assume that economies are stable, investors behave rationally and over time asset prices will “converge” with their intrinsic value. Most assets are invested in and benefit from convergent strategies. Divergent strategies, on the other hand, assume that economies are not always stable, investors do not always behave rationally and from time to time asset prices “diverge” from their intrinsic values. After all, humans are social animals subject to emotions that occasionally interfere with sound judgement. This leads us to ask – do divergent strategies have a place in your portfolio?
Over time, convergent strategies will deliver attractive long-term rates of return but experience occasional large losses like the Global Financial Crisis and the bursting of the tech bubble. Over the last two years, the S&P 500 has produced strong returns despite increased volatility and the sharp selloff in March due to the pandemic. However, if history is any guide the next major structural bear market is always in front of us.
January 2019 – September 2020
| CAGR | Std Dev | Max DD (Month end) | Sharpe Ratio | Sortino Ratio | US Mkt Correlation | |
| S&P 500 | 20.48% | 19.89% | -19.43% | 0.97 | 1.51 | 1 |
Divergent strategies are characterized by infrequent, but occasional, large gains caused by market dislocations. Let us see what happens when we add a component of a divergent investment strategy to the portfolio mix. When we take 20% from the S&P 500 and invest it in a divergent investment strategy, we are able to achieve nearly 88% of the return of the S&P 500 at a 17.96% compounded annual growth rate (CAGR) with 18% less risk as measured by the standard deviation of return (Std Dev) and a 25% reduction in the maximum drawdown (Max DD) or peak to trough loss measured at month end. We can achieve an attractive return with measurably less risk and, as a byproduct, the Sharpe and Sortino Ratios improve.
January 2019 – September 2020
| CAGR | Std Dev | Max DD (Month end) | Sharpe Ratio | Sortino Ratio | US Mkt Correlation | |
| 80% S&P 500 / 20% Divergent | 17.96% | 16.23% | -14.65% | 1.01 | 1.64 | 0.97 |
| S&P 500 | 20.48% | 19.89% | -19.43% | 0.97 | 1.51 | 1 |
When we take 30% from the S&P 500 and invest it in a divergent investment strategy, we can achieve 81% of the return of the S&P 500 at a 16.69% CAGR with 26% less risk measured by the standard deviation and a 38% reduction in the maximum drawdown measured at month end. The Sharpe and Sortino Ratios continue to improve as the portfolio becomes more efficient.
January 2019 – September 2020
| CAGR | Std Dev | Max DD (Month end) | Sharpe Ratio | Sortino Ratio | US Mkt Correlation | |
| 70% S&P 500 / 30% Divergent | 16.69% | 14.79% | -12.13% | 1.02 | 1.68 | 0.92 |
| S&P 500 | 20.48% | 19.89% | -19.43% | 0.97 | 1.51 | 1 |
Finally, when we take 40% from the S&P 500 and invest it in our divergent strategy, we can achieve 75% of the return of the S&P 500 with a 31% reduction in risk as measured by standard deviation and less than half of the maximum drawdown. The portfolio is much less dependent on the S&P 500 with a correlation to the broader market of 0.83.
January 2019 – September 2020
| CAGR | Std Dev | Max DD (Month end) | Sharpe Ratio | Sortino Ratio | US Mkt Correlation | |
| 60% S&P 500 / 40% Divergent | 15.41% | 13.74% | -9.51% | 1.01 | 1.66 | 0.83 |
| S&P 500 | 20.48% | 19.89% | -19.43% | 0.97 | 1.51 | 1 |
In investing, there is no right or wrong answer when it comes to an asset allocation. We each have our own levels of risk tolerance and it is the role of the investment advisor to build a portfolio for the client commensurate with that risk. I often hear from investors how much money they have made on an investment. The reality is that return is meaningless in a vacuum. Return is only meaningful when one understands the risk that was taken to achieve it. Bond yields have come down sharply over the last four decades calling into question the efficacy of bonds as a portfolio diversifier in the years ahead. Due to the collapse in interest rates, investors have been forced further out on the risk curve to achieve their objectives, especially retirees. With an uncertain economic future, exacerbated by the pandemic, divergent investment strategies may play a pivotal role in investment portfolio returns in the years to come.
Disclaimer
Data used in this post is from January 2019 to September 2020. The S&P 500 Index® is a widely used proxy of the U.S. equity market. Investments cannot be made directly into the index. Data used in this post referencing the S&P 500 used SPY as its proxy. For divergent strategy data we have used the Tahoe Fund, LP. Data for the The Tahoe Fund, LP was provided by Incline Investment Management, LLC and represents the strategy’s performance net of fees.