Diversification in 2014

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Diversified portfolios provided modest results in 2014, especially in the second half of the year. While the U.S. Large Cap sector achieved double-digit returns, most other sectors in equity, fixed income, and alternative investments produced significantly lower or negative results. This narrow market participation created an environment where a well-diversified portfolio invested in many areas of the market achieved only a fraction of the return of the large cap indexes like the S&P 500.

It’s tempting to second guess diversification when headline news is focused on only one segment of the market that performed particularly well, but we know that concentrating a portfolio in only one sector can be a risky and dangerous endeavor. The theory behind diversification is that over time, a portfolio of different kinds of investments will provide higher returns and lower risk than a portfolio concentrated in only one area of the market. Diversification is intended to smooth out unsystematic risk in a portfolio so that the positive performance of some investments will help offset the negative performance of others. We experience this phenomenon every year and 2014 was no exception. For example, the negative performance of international and commodity markets was offset by the positive performance of U.S. equity and fixed income markets. In other years, different categories become the leaders and laggards. While diversification worked in 2014, overall performance can look disappointing when compared against the best performing sectors of the market.

In this piece, we look at several of the sectors of the market that were laggards in 2014, and explain why we allocate to these sectors and why we believe they continue to be an important component of a diversified portfolio.

Why we allocate to it
An allocation to international investments provides exposure to markets beyond the U.S. that represent over 75% of the world’s economy. Many of these countries are growing at different rates than the U.S. and are at different points in their economic cycles, providing additional potential sources of return. International investing can also provide a currency hedge against a declining dollar as exposure to other currencies can counterbalance this effect.

2014 Results and 2015 Outlook
Fears of a continued slowdown in Europe hurt European and Asian stocks. Compared to their U.S. peers, international stocks currently trade at a discount making them attractive from a valuation standpoint. While we take into account the risks of a return to a recession or anemic growth in Europe, the relative value provides a substantial potential benefit to long-term investors. Plus, the U.S. dollar may have moved too far too fast—it ended 2014 up 12.8%, the largest annual gain in the past 17 years. A double-digit gain in a currency within a year is highly unusual, and some ensuing giveback is quite possible.

Why we allocate to it
A well-diversified portfolio can benefit from an allocation to alternative investments because their returns generally have a lower correlation with those of standard asset classes (stocks and bonds). This exposure can provide protection from systematic market risk factors as the performance of alternatives is not tied to the direction of the broader markets. Many of the strategies in this asset class are designed to minimize risk, and hold up better when markets are volatile or falling. When market volatility increases, alternatives become more critical to help minimize portfolio swings.

2014 Results and 2015 Outlook
Alternatives were generally flat for the year, behind U.S. stock and bond markets but ahead of international markets. When the markets dipped at various periods in 2014, alternatives held up better. Alternatives can provide this buffer in portfolios when larger, unexpected corrections occur in the market. They can also provide unconventional sources of return when the markets are going down.

Why we allocate to it
An allocation to commodities can provide an important component of diversification and an inflation hedge to portfolios that a strict equity/fixed income mix does not.

2014 Results and 2015 Outlook
Commodity performance struggled in 2014 with fears of a global demand slowdown and, in certain instances, excess supply negatively impacted energy prices and those of precious metals. Although global economic expansion has slowed, there are still countries looking to spend money on infrastructure, which could potentially drive demand for many commodities. Our broad exposure to commodities, gained through diversified investments, serves to lessen the volatility that is emblematic of individual commodity positions. Despite the diversified exposure, plunging oil prices was the largest contributor of negative performance within the asset class. As global demand starts to pick up, we believe commodities will come back in favor and should experience price appreciation. While inflation has remained muted over the past few years, the significant monetary efforts by the U.S. and other countries across the world to keep economic growth going remains a threat that could impact inflation. While we do not think the threat is clearly imminent, we do think a small exposure to hedge that risk is still prudent.

History has shown that different asset classes will lead the way as the economic and financial conditions play out each year. Betting on which will be the leaders each year is an extremely difficult task. When constructing portfolios with a long-term view, combining many assets classes that have low correlations to each other has proven to be a prudent investment practice. This diversifying technique allows for maximizing the long-term return for a portfolio without taking on undo risk.

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The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.

Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.

Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.

Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.

Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.



The S&P 500 Index is an unmanaged index comprised of 500 widely held securities considered to be representative of the U.S. stock market in general. The Dow Jones Industrial Average (DJIA) is a price-weighted index of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq (the index covers all industries with the exception of Transportation and Utilities). The Nasdaq Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market. The Russell 1000 Index is a market capitalization-weighted benchmark index made up of the 1000 largest U.S. companies in the Russell 3000 Index. The Russell 2000 Index is an unmanaged index considered representative of small-cap stocks. The Russell 3000 Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market. The MSCI EAFE Index is designed to measure the equity market performance of developed markets outside of the U.S. & Canada. The MSCI Emerging Markets (EM) Index captures large and mid-cap representation across 23 Emerging Markets countries (EM countries include: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates). With 834 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. The S&P GSCI (formerly the Goldman Sachs Commodity Index) is a world-production weighted index that is based on the average quantity of production of each commodity in the index, over the last five years of available data. This allows the S&P GSCI to be a measure of investment performance as well as serve as an economic indicator. The HFRX Absolute Return Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. As a component of the optimization process, the index selects constituents which characteristically exhibit lower volatilities and lower correlations to standard directional benchmarks of equity market and hedge fund industry performance. The Barclays US Aggregate Bond Index is a market capitalization-weighted index of investment-grade, fixed-rate debt issues, including government, corporate, asset-backed, and mortgage-backed securities, with maturities of at least one year. The Barclays Global Aggregate Bond Index provides a broad-based measure of the global investment grade fixed-rate debt markets. It is comprised of the U.S. Aggregate, Pan-European Aggregate, and the Asian-Pacific Aggregate Indexes. It also includes a wide range of standard and customized sub-indices by liquidity constraint, sector, quality and maturity. The Barclays U.S. Corporate High Yield Bond Index is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market. The index is composed of U.S. dollar-denominated corporate debt in Industrial, Utility, and Finance sectors with a minimum $150 million par amount outstanding and a maturity greater than 1 year. The index includes reinvestment of income.

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