Chad Padowitz
“For years, investors were rewarded simply for being in the market. But we are moving into an environment where what you own matters again — and that may catch many people off guard,” Talaria Capital Co-CIO Chad Padotitz says.
“Major indices are now concentrated in a relatively small group of technology companies, while correlations across markets have risen. The traditional safety net of diversification is becoming less reliable.”
“For investors, genuine diversification is becoming both harder to find and more important.”
Recent market movements have provided a reminder that diversification can still exist within equities. In June, for example, growth and technology stocks weakened while financials, health care and industrials posted strong gains.
Across asset classes, however, the longer-term trend has been in the opposite direction. More than 90 per cent of global investable assets — including bonds, international equities, REITs, private assets and much of the hedge fund universe — now have a meaningful correlation with the S&P 500.
Padowitz says the result is that portfolios that appear diversified can still be exposed to many of the same underlying market forces — including the extraordinary concentration of capital and expectations around artificial intelligence.
“For much of the past three decades, falling financing costs and strong cashflow growth pushed asset prices higher. At the same time, lower correlations between asset classes meant weakness in one area could often be offset by strength in another.
“That environment rewarded investors for maximising their exposure to rising markets. But as conditions change, genuine diversification becomes increasingly valuable,” Padowitz says.
“Any investor can feel on top of the world when their assumptions about the world are holding. The real test comes when conditions change.
“The challenge is finding sources of return that behave differently, rather than simply adding more assets to a portfolio.”
One potential source is the volatility risk premium, which can be accessed by selling fully cash-backed put options over individual equities and receiving a premium for assuming that market risk.
Options are priced using implied volatility — the market’s expectation of future volatility — which has historically tended to exceed the volatility subsequently realised. This difference can provide option sellers with an additional source of return alongside the potential capital growth from owning equities.
Importantly, there can also be a significant difference between volatility at the individual-stock level and at the index level. Active managers can seek to take advantage of higher single-stock volatility, using the premiums received to lower the effective entry price into equities and generate returns that are not solely dependent on markets rising.