Illustration by S. Kambayashi

THERE is such a thing as a free lunch. That, at least, is what pension funds have been told in recent years. Diversify into new asset classes and your portfolio can improve the trade-off between risk and return because you will be making uncorrelated bets.

Boy, did pension funds diversify. They bought emerging-market equities, corporate bonds, commodities and property, while giving money to hedge funds and private-equity managers with their complex strategies and high fees.

The idea was to “be like Yale”, the university endowment fund run by David Swensen, a celebrated investor, which started to diversify into hedge funds and private equity in the 1980s. Compared with other institutional investors over the past 20 years, Yale had very little exposure to conventional equities. It also produced remarkably strong returns.

But those who thought Yale had found the key to success have been disappointed. Every one of those diversified bets has turned sour this year. In retrospect, it looks like the strategy had two problems. The first was that all risky assets were boosted by the same factors: low interest rates and healthy global growth. That encouraged investors to use leverage, or borrowed money, to enhance returns. The result was what Jeremy Grantham of GMO, a fund-management group, describes as “the first truly global bubble”. As confidence has unravelled, investors have been forced to sell all those asset classes simultaneously, driving down prices across the board.

The second, and related, problem is that some of the asset classes were quite small. Initially, this illiquidity was attractive since it seemed to offer more alluring returns. And as more investors became involved, their liquidity duly improved. But they still suffer from the “rowing boat” factor. When everyone tries to exit the asset class at once, the vessel capsizes.

Furthermore, some of these asset classes were always likely to be driven by the same factors as stockmarkets. Private-equity funds, for example, give investors exposure to the same kinds of risks as quoted companies, only with added leverage.

So was the whole idea of diversification a write-off from the start? The strategy's defenders say no. They argue that pension funds (and other institutional investors) had made too big a bet on equities in the 1990s. When the bet went wrong with the bursting of the dotcom bubble, funds went into deficit.

They accept that, in a crisis, correlations head towards one; in other words, all asset classes (except government bonds) tend to fall together. But the diversifiers have three counter-arguments. The first is that any correlation less than one is still worth having. Hedge funds may have performed badly this year but their losses have been far lower than those of equity markets.

Second, there is a difference between short-term correlations and long-term ones. If you take a five- or ten-year view, it still looks as if property, commodities and the rest offer some diversification benefits. They did so during the equity bear market of 2000-02, for example.

Third, consultants like Colin Robertson of Hewitt Associates argue that diversification does work when it is applied in a sophisticated way. There is no point in diversifying if the investment does not offer a genuinely different source of return (much of private equity falls into this category) or if the asset is already overvalued.



The final problem with diversification has been the cost. Investing in quoted shares via an index fund is very cheap—a fraction of a percentage point. But diversified asset classes cost more to trade and involve higher management fees, expenses that eat into pension-fund returns.

So perhaps diversification has been a free lunch after all. Not for the pension funds, but for the fund managers.