Odd Lots Podcast Episode Summary

Title: Krishna Memani on Wall Street's Very Expensive "Free Lunch"
Host/Authors: Joe Weisenthal and Tracy Alloway
Guest: Krishna Mamani, Chief Investment Officer of Lafayette College Endowments
Release Date: May 30, 2025

1. Introduction: Rethinking Diversification

In this episode of Odd Lots, hosts Joe Weisenthal and Tracy Alloway delve into the age-old investment principle of diversification. Challenging its efficacy, they converse with Krishna Mamani, a seasoned Chief Investment Officer, to explore why diversification, long touted as a "free lunch" in investment strategy, may no longer deliver the promised benefits.

2. Diversification: The Traditional Mantra

Joe Weisenthal [02:07]:
"Tracy, this has come up a few times on the podcast over the years, but, you know, you really feel, you could really feel dumb as an investor over the last, I don't know, 15, 20 years, if you literally bought anything else besides big tech stocks."

Tracy Alloway [02:22]:
"Big US Tech stocks."

Discussion Highlights:

• Historical Context: For the past two decades, big U.S. tech stocks have significantly outperformed other sectors.
• Diversification Challenge: Despite the longstanding advice to diversify internationally and into small caps, these strategies have underperformed compared to concentrated investments in U.S. tech.

3. Theoretical Foundations of Diversification

Krishna Mamani [05:40]:
"Diversification is the biggest free lunch available in the investment world. And I think from a longer term perspective that is absolutely true..."

Discussion Highlights:

• Origins: The principle of diversification stems from Modern Portfolio Theory and the Capital Asset Pricing Model (CAPM), pioneered by academics like William Sharpe in the 70s and 80s.
• Basic Premise: By spreading investments across various assets, investors can mitigate unsystematic risk without sacrificing expected returns.

4. Why Diversification Has Fallen Short

Krishna Mamani [08:03]:
"...the fact that it hasn't worked out according to plan doesn't mean that the basic principle isn't invalidated. It just simply means that you have to think about it and acknowledge the fact that it hasn't worked out according to plan."

Discussion Highlights:

• Long-Term Underperformance: Over the past 30-40 years, diversified portfolios, especially those including international stocks and small caps, have not matched the performance of concentrated investments in U.S. tech giants.
• Benchmark Influence: Benchmark indices like MSCI All World Index compel investors to buy certain asset classes, often leading to suboptimal diversification.

5. The Dominance of U.S. Tech Stocks

Krishna Mamani [10:36]:
"...the tech supremacy of The S&P 500 is certainly one of the drivers behind diversification's underperformance."

Discussion Highlights:

• Profitability and Growth: U.S. tech companies have maintained high profitability and growth, attracting significant investment flows.
• Low Interest Rates: Persistently low interest rates in the U.S. have favored growth stocks, particularly in the tech sector.
• Private Equity Influence: High multiples in private equity markets have further bolstered the performance of U.S. tech firms.

6. The Role of Benchmark Index Providers

Krishna Mamani [18:46]:
"...benchmarks come in because otherwise it'll be free for all. As an asset allocator, if my returns were 10%, let's say I can always claim that I did a fabulous job and my benchmark outperformed by, you know, 1,000 basis points."

Discussion Highlights:

• Influence on Allocation: Benchmark providers like MSCI and S&P Global actively shape asset allocations by determining index compositions.
• Tyranny of Benchmarks: While benchmarks provide a framework for performance evaluation, they also constrain investment strategies, sometimes leading to herd behavior and concentrated investments.

7. International vs. U.S. Market Performance

Joe Weisenthal [28:34]:
"Tracy, do you know how much without looking the dax Germany's benchmark index, do you know how much it's up in dollar terms this year?"

Tracy Alloway [28:42]:
"I do not. Although I will confess I have a chart of the MSCI All World versus the S&P 500. Almost."

Notable Quote: Joe Weisenthal [28:53]:
"The German stocks in dollar terms are up 32% this year. France up 17.5% in dollar terms, the Euro stocks up 22%. I mean, this is serious."

Discussion Highlights:

• Regional Outperformance: European and Latin American stocks have shown remarkable gains in the current year, diverging sharply from the flat performance of U.S. benchmarks.
• Flow Dynamics: Krishna attributes U.S. dominance to dollar-related global flows and the perceived strength of the U.S. economy, which have historically drawn investment into the U.S.
• Sustainability Concerns: While current international markets are performing well, there's skepticism about the longevity of these gains without structural economic changes.

8. Career Risk and Investment Strategy

Joe Weisenthal [20:29]:
"Talk to us, though, about like your peers and career risk, et cetera..."

Krishna Mamani [24:27]:
"So, Krishna Mamani. That seems like a really key point that as long as that's the benchmark, some institutional allocation will survive."

Discussion Highlights:

• Pressure on Asset Managers: Institutional investors face career risks if their diversified strategies underperform benchmarks, leading some to deviate from traditional diversification in pursuit of higher returns.
• Crowded Trades: Managers may flock to popular sectors like U.S. tech to outperform, risking reduced performance if these sectors falter.

9. Diversification's Role in Tail Risk Protection

Tracy Alloway [31:12]:
"But if the argument is diversification is good for protecting you from tail risks, then what's been happening this year, and specifically in April, seems like a pretty big tail risk. And diversification worked in this case?"

Krishna Mamani [31:27]:
"Absolutely, diversification worked."

Discussion Highlights:

• Short-Term Benefits: Diversification can provide peace of mind during acute market stress by mitigating drastic losses.
• Long-Term Underperformance: Despite short-term benefits, over extended periods, diversified portfolios have lagged behind concentrated investments in high-performing sectors.

10. Krishna Mamani’s Personal Approach to Diversification

Krishna Mamani [34:56]:
"I have constructed my portfolio in a very diversified way. It has worked out fine, but it could have worked a lot better for that."

Discussion Highlights:

• Acknowledgment of Limitations: While maintaining a diversified portfolio personally, Krishna recognizes that this approach has limited his potential gains.
• Valuation Context: He emphasizes the importance of considering valuation metrics and current economic environments when constructing diversified portfolios.

11. Conclusion: Re-evaluating Diversification Strategies

Krishna Mamani [36:05]:
"I think ... when the opportunity comes back, we are kind of thinking about it the right way rather than just sticking to the mantra that we have thought about for the last 30 years."

Discussion Highlights:

• Need for Adaptation: The traditional approach to diversification may require reevaluation and adaptation in light of recent market dynamics.
• Future Research: There's a pressing need for research into the drivers behind diversification's underperformance and the development of new investment methodologies.
• Balanced Perspective: While diversification has its merits, especially for risk management, investors should critically assess its efficacy and remain open to alternative strategies.

Key Takeaways

• Historical Context Matters: Traditional diversification strategies, heavily reliant on international and small-cap stocks, have underperformed compared to concentrated investments in U.S. tech over the past two decades.

• Benchmark Influence: Index providers play a significant role in shaping investment allocations, sometimes leading to concentrated holdings that may not always align with optimal diversification principles.

• Market Flows and Currency Impact: U.S. market dominance is partly driven by global investment flows favoring the strength of the dollar and the profitability of U.S. tech firms.

• Short-Term vs. Long-Term Benefits: Diversification offers valuable risk mitigation during market downturns but may limit returns during prolonged bull markets in concentrated sectors.

• Evolving Strategies Needed: Investors and asset managers must reassess and potentially innovate beyond traditional diversification to navigate the changing financial landscape effectively.

For more insights and discussions on finance, markets, and economics, visit Bloomberg Odd Lots.