Conventional Diversification Doesn't Work

Diversification the old-fashioned way produces underperformance, Genworth's Tim Knepp says.
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NEW YORK (TheStreet) -- For years, institutional investors followed standard strategies. Institutions maintained static portfolios, keeping 60% of assets in stocks and most of the rest in fixed income. The approach worked beautifully in the 1990s, but it has produced skimpy results in the past decade.

Now more advisers are challenging the traditional thinking. Among the more interesting dissenters is Tim Knepp, chief investment officer of

Genworth Financial Advisors

, who oversees $7 billion in assets.

Knepp says standard strategies failed to protect investors during the stock-market meltdown. To support his view, he cites data on performance of portfolios during the 10 years ending in 2009. During that period, a portfolio that was 60% in the

S&P 500 Index

and 40% in the

Barclays Aggregate Bond Index

would have returned a meager 2.3% annually. In the downturn of 2008, the diversified portfolio would have lost 22%. The results would have also been poor in portfolios that included a variety of assets, such as small-cap stocks, commodities and foreign bonds.

Seeing such data, proponents of conventional diversification remain unmoved. They say that by holding a standard 60-40 portfolio long enough, investors will obtain decent results. Knepp counters that investors who stick with static allocations are bound to suffer big losses periodically. He says investors should make tactical moves, shifting allocations as different assets become riskier. "There are some years when an investor who can stand moderate risk should have 60% in equities, and other years when it would be appropriate to have 70% of assets in bonds," he says.

Genworth offers a series of portfolios designed for investors with different risk tolerances. The portfolios, sold by financial advisers, invest in mutual funds as well as individual securities. The most aggressive portfolio is for investors who can stand to lose 20% of their assets in one year. When risks became greater toward the end of 2008, the aggressive portfolio had 35% of assets in equities. Now that markets have stabilized, the equity allocation has been raised to 70%.

Proponents of standard diversification suggest holding broad collections of stocks that track benchmarks, such as the S&P 500. But Knepp often emphasizes narrow sectors. Lately he has been targeting mutual funds that can prove resilient during market downturns.

A favorite holding is

Lazard Global Listed Infrastructure

(GLFOX) - Get Report

, which invests in companies that own a variety of assets, including ports, railways and pipelines. Knepp says countries around the world are continuing to invest heavily in infrastructure projects. Stocks in the sector tend to be steady performers that can deliver reliable income, even during economic downturns.

Knepp is particularly cautious with his bond holdings. With governments borrowing more, yields on bonds are likely to rise, he figures. That will hurt returns of conventional bond funds that hold broad collections of investment-grade issues. To limit risks, he owns

Driehaus Active Income

(LCMAX) - Get Report

, which has little correlation with typical bond funds. Driehaus buys bonds from companies with positive outlooks and sells short bonds from weaker issuers. The goal is to deliver steady returns with little volatility. Knepp says the fund can make money in up and down markets.

Another holding is

Aberdeen Asia Bond

(CSABX)

. The fund can provide diversification because Asian currencies sometimes rise when the dollar is falling. Knepp says Asian bonds yield more than comparable U.S. issues. Investors demand the extra yield because they consider developing economies riskier. But Knepp says Asian bonds are undervalued. At a time when Asian countries are growing rapidly and keeping their debt under control, the region's bonds should be priced more in line with markets in the developed world.

Knepp worries that interest rates will rise in Asia as economies expand. But he says Aberdeen fund managers have the flexibility to adjust the portfolio to protect shareholders from the hazards of inflation and difficult bond markets.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.