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Introduction

The message is simple…diversification is good—Super-Diversification is better!

Investors generally understand this investment equation. In layman’s terms, diversification is to have multiple investments in a portfolio with the goal of reducing risk, or minimizing losses, while still producing an acceptable performance. In more technical terms, investors are looking for less volatility, or standard deviation, while receiving a comparable or better return.

The impact and benefits of diversification are best understood by reviewing the provided examples. Note that several assumptions must be made. The most important is that each asset class, such as U.S. large-cap stocks, is represented by a popular industry acceptable index, such as the S&P 500. Today investors can easily and inexpensively gain access to these asset classes, or indexes, via exchange traded funds, or ETFs. All estimated costs have been subtracted in an effort to represent net of fees results.

Growth Portfolio Analysis Examples

Portfolio Analysis

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Portfolio Name
Asset Classes
Compounded Returns
Risk Characterstics
The “Non-Diversified” Portfolio

Let’s start with a “Non-Diversified” portfolio. The most extreme example of such a portfolio would be one that owns just one company stock. In the opinion of most informed investors, this is not a wise or viable strategy. Instead, we will define a “Non-Diversified” portfolio as one that represents just one asset class, U.S. large-cap stocks represented by the S&P 500. Analysis of such a portfolio is straight-forward, it is simply an analysis of the performance of the S&P 500 Index. This will be our benchmark for evaluating the impact and benefits of diversification.

The results for this “Non-Diversified” portfolio are presented in the accompanying table. It compounded at 8.3% annually but all investors in stocks know that this was simply not a steady climb higher. Of the 44 years covered in this analysis, 11 years had losses,2008 being the worst, down -38.2%.

A highlight of the worst year, 2008, does not measure the full magnitude of losses incurred by this portfolio. The accompanying graph illustrates one of the worst total losses sustained by this “Non-Diversified” portfolio, a 46.3% loss during the 2000-2002 bear market. This is an illustration of a “Drawdown”. The accompanying graph further illustrates the 85 months to return to the previous high, an example of measuring “Peak-to-Peak” recovery times.

The bear market of 2007-2009 has produced the worst drawdown, or “Maximum Drawdown” from the table on the previous page, during the 44 years of analysis. A similar loss also occurred during the bear market of 1973-1974 of -44.5%. This “Non-Diversified” portfolio consisting entirely of large-cap U.S. stocks produced acceptable long-term returns but exposed investors to a significant level of risk.

“Traditionally Diversified” Portfolios

Portfolio Analysis

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Difference in
Performance
Portfolio Name Difference in Performance
Asset Classes
Compounded Returns
Risk Characterstics

Let’s now consider two traditionally diversified portfolios with allocations to a mixture of traditional stocks and bonds.

The first is named the “Simply Diversified” portfolio. It consists of an allocation to just 4 asset classes including U.S. stocks, both large-cap and small-cap, international stocks in developed countries, and U.S. government bonds. Overall, it is a 70% allocation to stocks and 30% allocation to bonds, traditionally considered to be a growth oriented portfolio (portfolios for income oriented investors are presented in a later section titled “Income Portfolio Analysis Examples”). The analysis results for this portfolio are in the accompanying table.

This diversification had an immensely positive impact! The return moved down slightly, the impact of the added diversification in the portfolio, and the risk dropped sharply, improvements in every risk characteristic (negative green numbers for Risk Characteristics indicated a reduction in risk which is a positive result). For example, volatility dropped by 29%. The performance

during both the worst month and worst year were substantially improved, both losses cut by approximately one-third. The worst total loss, or Maximum Drawdown, was cut by 25% and the longest time to recover was cut by more than 2 years! These are the types of results any investor would appreciate.

Many investors ask how can this possibly work and the answer is relatively simple. By diversifying, all of the investments in your portfolio are not always going up and down together. To help provide more clarity, the accompanying graph illustrates the performance of each asset class in the “Simply Diversified” Portfolio during the 2000-2002 bear market and following recovery.

The green line in the above graph illustrates the performance of the “Simply Diversified” Portfolio and the accompanying lines represent the performance of each individual asset class in the portfolio. As you can see, U.S. Large-Cap Stocks and International Stocks had nearly identical losses during the bear market with International Stocks recovering much more rapidly. U.S. Small-Cap stocks experienced a much smaller loss during this time period and was then followed by a very strong move higher. Bonds steadily marched higher during nearly the entire time period. Diversification among these 4 asset classes clearly reduced an investor’s risk during this bear market and tends to do the same during other market time periods.

As outlined earlier, this analysis is performed by simulating a portfolio allocated as illustrated in the table. It is assumed that each asset class performs just as a representative market benchmark performed. For example, returns for U.S. Large-Cap Stocks were assumed to perform as the S&P 500 performed and U.S. Mid-term Government Bonds performed as the Barclays Capital U.S. 7-10 Year Treasury Bond Index performed. The performance of these asset classes, and market benchmarks, can be replicated in a portfolio today via Exchange Traded Funds.

Portfolio Analysis

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Difference in
Performance
Portfolio Name Difference in Performance
Asset Classes
Compounded Returns
Risk Characterstics

As mentioned at the start of this section, we are going to take a look at two Traditionally Diversified portfolios. The first was the “Simply Diversified” with just 4 asset classes. The next Traditionally Diversified portfolio contains allocations to 11 asset classes. Both have a 70% allocation to stocks and 30% allocation to bonds. This second portfolio has been named the “Grand Illusion” because of its stunning similarity in results to the “Simply Diversified” Portfolio.

The analysis for this portfolio was conducted just as described for the “Simply Diversified” Portfolio and uses popular market benchmark indexes to represent the performance of the various asset classes.

The results for the “Grand Illusion” portfolio are presented in the accompanying table.

The overall return was nearly identical, possibly to be expected by the perception of added diversification, but the risk also increased (represented by the positive red numbers) which is not desirable. During different time periods, the differences between the “Simply Diversified” portfolio with just 4 investments and that which appears more sophisticated and diversified with 11 investments, are negligible. Many investors have a portfolio that has the appearance of more diversification. I call this the “Grand Illusion” because these investors have the illusion that their portfolio will be protected during severe market declines which is simply NOT the case.

Investors logically ask why this added diversification would not help. Again, the answer is relatively simple. Statistically, many of the investments in the “Grand Illusion” Portfolio are highly correlated, or move up and down at the same time. As a result, splitting U.S. Large-Cap Stocks into two pieces, Value and Growth, provides virtually no noticeable benefit.

Bear Markets

Bear Period
Note: 2007-2009-10/31/2017-2/28/2009

There is further evidence by reviewing the performance of each portfolio during the 4 most recent bear markets as illustrated in the accompanying table. I show the “Non-Diversified” portfolio for comparison purposes. Again you will see that the seemingly more diversified “Grand Illusion” portfolio provided virtually no added benefit during these bear markets as compared to the “Simply Diversified” portfolio.

It requires little convincing that a properly diversified portfolio is the correct method for investing. Giving up a small fraction of long-term returns can result in a significant drop in risk.

The “Super-Diversified” Portfolio

Super-Diversification is simply diversifying a portfolio into a broader range of investments, in particular less correlated investments, which deliver further diversification benefits of even lower risk while also achieving comparable or even better returns.

Many investors, in particular individual investors, stop far short of Super-Diversification. However, Patton provides an opportunity for investors through proprietary investments to realize the benefits of a “Super-Diversified” Portfolio.

The goal of Patton’s “Super-Diversified” Portfolio is simple…help individuals achieve more diversification benefits of reduced risk and comparable or better long-term returns. Many large institutional investors are recognizing some or all of the benefits available from super-diversification. The Yale Endowment provides a great prototype for this methodology and provides an excellent example of success that can be achieved through super-diversification. During the past decade the Endowment has compounded annually at 10.0% compared to 4.2% for our “Simply Diversified” portfolio.

Portfolio Analysis

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Difference in
Performance
Portfolio Name Difference in Performance
Asset Classes
Compounded Returns
Risk Characterstics

Patton’s “Super-Diversified” Portfolio is designed to increase exposure to a wider variety of investments including hedge strategies, hedge funds, private equity, real estate, commodities, and more international securities with relatively low expenses. By doing so, our goal is to achieve returns within these asset classes that are similar to the asset classes’ average return resulting in tremendous benefits for investors…the benefits of super-diversification!

There are two steps to be taken on the way to a “Super-Diversified” Portfolio, both adding diversification. The first is to diversify among additional asset classes that are easily accessible to all investors via low cost ETFs. These additional asset classes include International Emerging Stocks, Real Estate, Commodities, and Berkshire Hathaway, serving as a substitute for Private Equity.

The accompanying analysis, both portfolios having a growth orientation, clearly illustrates the benefits of this better diversification of both higher returns and less risk. The return of this “Better Diversified” Portfolio jumped to 10.0%, up sharply from the 7.8% for the Simply Diversified. The risk profile improved significantly on some key statistics including lower volatility, fewer down years, and a far shorter recovery of just 39 months as compared to 58 for the Simply Diversified.

This “Better Diversified” Portfolio can be easily implemented by investors with nearly any size portfolio. The accompanying table lists each asset class and the ETF/stock that can be purchased to represent each asset class. ETFs trade just as stocks so they can be bought and sold just the same in nearly any brokerage account.

Some investors may question if

owning just 10 securities in an account provides adequate diversification and the answer is clearly “yes”. The accompanying table of ETFs also illustrates the number securities underlying each single ETF. For example, the U.S. Large-Cap Stocks ETF symbol SPY mimics the performance of the S&P 500 and, therefore, has more than 500 underlying stocks. This portfolio of 10 ETFs has a total of a few thousand underlying securities.

Regular rebalancing of the asset classes is an important component of the long-term success in any portfolio. This process is often ignored by investors. For those that do attempt to rebalance, they often find it difficult because it is the process of selling some of the best performing assets and buying the poorer performing, a process that goes against the emotions of most investors. Patton Fund Management can manage your portfolio for a nominal fee of just 0.5% annually. Management of your account by Patton includes systematic rebalancing of the asset classes as often as monthly, eliminating all emotions from the process. Furthermore, Patton is continuously searching for additional investment opportunities that can provide added long-term value to your portfolio.

Portfolio Analysis

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Difference in
Performance
Portfolio Name Difference in Performance
Asset Classes
Compounded Returns
Risk Characterstics

The above analysis is only the first of two steps toward a “Super-Diversified” Portfolio. The second step is the addition of our proprietary Patton Edge Strategy, a U.S. stock hedging strategy along with a notable reduction in the allocation to bonds.

The addition of the Patton Edge Strategy provides further diversification benefits. The following analysis clearly illustrates these benefits, both higher expected returns with less risk. For example, the return during this period of time was 21% higher than the return for the “Better Diversified” Portfolio and the portfolio risk continued to drop.

It is important to note that almost regardless of the time period considered for analyses, the results of the “Super-Diversified” Portfolio are superior. For example, during major bull markets, when stock prices are moving persistently higher, the difference in returns are often marginal between the two portfolios. But true to the goal of

reducing risk, during periods of major bear markets, when stock prices move relentlessly lower, the “Super-Diversified” Portfolio produces much improved returns, minimizing the risk of capital losses.

The overall impact of super-diversification provides added investment security and investor peace of mind combined with the expectation of higher long-term returns, all paramount for any investor’s portfolio.

Investors will logically again ask how is it that this “Super-Diversified” Portfolio can accomplish such results. As demonstrated and discussed earlier, when diversifying among investments that are highly correlated, those that move generally up and down together, few if any benefits are realized. Instead this “Super-Diversified” Portfolio is diversified among investments with relatively low or no correlation which produces these desirable results.

The following table summarizes all five growth oriented portfolio examples side-by-side for comparative purposes.

Portfolio Analysis

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Portfolio Name
Asset Classes
Compounded Returns
Risk Characterstics
See Patton Edge Strategy performance notice in the appendix

Income Portfolio Analysis Examples

Portfolio Analysis Examples

“Super-Diversified” Portfolios can be customized for each individual investor. The previous sections of this paper illustrated portfolios with a growth orientation. Super-Diversification is also a great Total Portfolio Solution for income oriented investors.

The “Non-Diversified” INCOME Portfolio

Portfolio Analysis

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Portfolio Name
Asset Classes
Compounded Returns
Risk Characterstics

Again, let’s start with a “Non-Diversified” portfolio. As we did in the previous growth oriented example, we will define a “Non-Diversified” portfolio as one that represents just one asset class. In this case, with an income orientation, we will use U.S. long-term government bonds. Analysis of this portfolio is straight-forward, it is simply an analysis of the performance of the Barclays Capital U.S. 7-10 Year Treasury Bond Index. This will be our benchmark for evaluating the impact and benefits of diversification for income oriented investors.

The results of this “Non-Diversified” income oriented portfolio are represented in the accompanying table. It compounded at 5.0% annually. Few investors in bonds seem to recognize the degree of risk associated with this investment. For example, since 1972 mid-term government bonds have produced negative returns in 9 years with the worst being a calendar year loss of 11.6%.

In addition to 9 years of negative performance, mid-term government bonds experienced their worst loss leading up to the market crisis in 2008. During a 24 month period, bonds lost 16% as highlighted in the adjacent graph. This is illustrated as “Maximum Drawdown” in the previous table. This “Non-Diversified” Portfolio of mid-term government bonds did not fully recover until September 2011, more than 6 years later! In conclusion, this portfolio produced a somewhat acceptable long-term return but exposes investors to more risk than is generally considered when investing in what is considered to be one of the safest investment in the world.

Traditionally Diversified Bond Portfolio

Portfolio Analysis

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Difference in
Performance
Portfolio Name Difference in Performance
Asset Classes
Compounded Returns
Risk Characterstics

Many conservative investors would logically conclude some diversification would provide balance to the “Non-Diversified” portfolio. Let’s consider one represented in the adjacent table that is an equal mix of 1) long-term government bonds, 2) mid-term government bonds, and 3) long-term corporate bonds. I’ve named it the “Bonds Blend” portfolio.

This diversification had a mixed impact for the risk adverse investors. Analysis of the “Bonds Blend” portfolio shows long-term returns would be fractionally higher at 5.2% as compared to 5.0% for the “Non-Diversified”. Again, more important to conservative investors is the possibility of reduced risk when adding diversification to a portfolio. Unfortunately, the added diversification in this portfolio produced very mixed results on the risk profile. Volatility jumped by 30% while the worst down month fell by 28%. Clearly mixing a variety of different bonds in a portfolio does little for the portfolio when looking at both long-term returns and the level of risk the investors is accepting.

Traditionally Diversified Income Portfolio

Most investors, even the most conservative, tend to prefer having a portion of their portfolio allocated to stocks. The most important factor for the conservative investor is whether or not additional diversification benefits, lower risk and comparable or higher returns, can be achieved with a relatively small allocation to stocks.

Portfolio Analysis

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Difference in
Performance
Portfolio Name Difference in Performance
Asset Classes
Compounded Returns
Risk Characterstics

The accompanying table, on the following page, illustrates the analysis of a common portfolio allocation for a conservative, income oriented investor. This portfolio consists of 1) 50% bonds, diversified among the same three types, 2) 25% stocks, both large-cap and small-cap U.S. stocks, and 3) 25% cash or T-Bills.

This added diversification did produce desirable results for any conservative investor. The long-term return increased slightly while the risk of the portfolio experienced significant improvements. The most notable improvement was the number of years with negative performance dropping to just 7 for the “Income Portfolio”, including the 25% allocation to stocks, while the portfolio with 100% bonds, as previously noted, experienced negative performance in 15 years. There were significant reductions in all of the other risk characteristics.

Many investors ask how can this possibly work? How can diversifying a portion of the portfolio into a higher risk asset such as stocks, reduce the overall risk of the portfolio. The answer is relatively simple. By diversifying beyond one asset class, namely bonds, all of the investments in your portfolio are not always going up and down together. To help explain this better, the following graph illustrates the performance of stocks and bonds during 1987, the year of the stock market crash.

The green line in the graph illustrates the performance of the “Income Portfolio” during 1987. The accompanying lines represent the performance of U.S. mid-term government bonds and U.S. large-cap stocks, the two major individual asset classes in the “Income Portfolio”.

The 1987 performance illustrates the balance that is added to a portfolio when a small allocation toward stocks is included. During the first 9 months of the year, stocks were rallying sharply while bonds posted fractional losses in value. During the crash in October, when stocks collapsed, and the selling that continued through November, bonds were rising in value. In both instances, the first 9 months of the year and the 2 months surrounding the crash, stocks and bonds helped provide balance for the other resulting in a combined portfolio with lower overall risk and volatility.

As outlined earlier, the analysis is performed by simulating portfolios allocated as illustrated in the tables. It is assumed that each asset class performs just as a corresponding market benchmark performed. The performance of these asset classes, and market benchmarks, can be replicated in a portfolio of Exchange Traded Funds.

The “Super-Diversified” Income Portfolio

Portfolio Analysis

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Difference in
Performance
Portfolio Name Difference in Performance
Asset Classes
Compounded Returns
Risk Characterstics

As discussed in an earlier section of this paper, Super-Diversification is simply diversifying a portfolio into a broader range of investments, in particular less correlated investments, which deliver further diversification benefits of generally even lower risk while also achieving comparable or even better returns.

Similar to the growth oriented portfolios discussed earlier in this paper, there are two steps toward a “Super-Diversified” Portfolio, both adding diversification. The first is to diversify among additional asset classes that are easily accessible to all investors via low cost ETFs. These additional asset classes include International Emerging Stocks, Real Estate, Commodities, and Berkshire Hathaway, serving as a substitute for Private Equity.

The accompanying analysis clearly illustrates the benefits of both reduced expected risk and comparable or higher

returns produced by this “Better Diversified” Portfolio. The return during this 44-year period was improved by 20%, jumping to 7.1% from 5.9% and the portfolio risk characteristics mostly showed a moderate improvement.

Portfolio Analysis

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Difference in
Performance
Portfolio Name Difference in Performance
Asset Classes
Compounded Returns
Risk Characterstics

The second step to a “Super-Diversified” income oriented portfolio is to include an allocation to our proprietary Patton Edge Strategy. The accompanying analysis shows a comparison of the “Better Diversified” Portfolio to this now “Super-Diversified” Portfolio.

The most significant improvement is a jump in the expected return to 8.5% from 7.1%. This significant jump in return does come with mixed results for the risk characteristics with some showing marginal increases in risk while others suggest a moderate reduction in risk.

It is important to note that when comparing the “Super-Diversified” Portfolio to the previously illustrate traditional Income Portfolio or the 100% bond portfolios, the risk profile of the “Super-Diversified” Portfolio is improved across all characteristics.

Also important to note that almost regardless of the time period considered for analysis, the results of both the “Better Diversified” Portfolio and the “Super-Diversified” Portfolio are superior. For example, during major bull markets, when stock prices are moving persistently higher, these two portfolios typically outperform the traditional “Income Portfolio”. Furthermore, during periods of major bear markets, when stock prices move relentlessly lower, the “Better Diversified” Portfolio and the “Super-Diversified” Portfolio generally produce marginally improved returns when compared to the traditional “Income Portfolio”.

The overall impact of Super-Diversification provides added investment security and investor peace of mind. This is combined with the expectation of generally reduced risk from the portfolio and significantly higher long-term returns. More specifically, for a conservative income oriented investor, there is the potential for more income.

Investors will logically again ask how is it that the “Super-Diversified” Portfolio can accomplish these results. As demonstrated previously, when diversifying among investments with relative low or no correlation, such as those in the “Super-Diversified” Portfolio, the desired benefits of lower risk and comparable or higher returns are possible.

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