One of the key underpinnings of modern-day investing is the concept of diversification. Adding assets to a portfolio will almost universally lower the overall volatility of a portfolio assuming that the correlation between the investment in question and the portfolio is lower than one. As the correlation falls the greater the drop in the volatility of the portfolio, i.e. the greater the diversification benefit.
Investors often fret about the lack of diversification opportunities in capital markets. The sentiment is especially pronounced during equity market selloffs such as what we have experienced this year.
Investors have been often discouraged by the high correlations observed among investments in the same asset class. For example, the early day (70’s and 80’s) arguments for increasing exposure to international equities hinged on the portfolio diversification benefits accruing from the low correlation between US and international stocks.
Sometimes expectations need to be re-adjusted. Unfortunately, as US investors increased their exposure to international investments and both US and foreign domiciled companies became more globally integrated the net result was a significant upward drift in correlations and a loss of diversification benefit.
The same story can be told about emerging market and even domestic small-cap investing. Investors looking for significant divergent behavior among equity sub-asset classes have been generally disappointed. Our latest estimates of the correlations of the S&P 500 to US Small Caps, International Stocks and Emerging Market Equity are all north of 0.7.
The long-term performance of these equity sub-asset classes will naturally gravitate towards their fundamental value, but over shorter holding periods the pull of the broad equity market factor will be unmistakable. Style, market cap and sector membership are secondary to what happens to the broad equity market. The market effect dominates.
The same applies within other asset classes. For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds. Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods
So where does that leave investors looking for a little zig when their portfolio zags? The answer is so simply and obvious but the message is often ignored. Bonds, bonds and more bonds. In recent times investors have shown a strong dislike for fixed income especially in light of the low prevailing interest rates.The same applies within other asset classes. For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds. Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods
From a prospective return perspective we agree, but, in our opinion, investors are forgetting about the diversification benefits of bonds. Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets.
Our current estimates of the correlation of US stocks to high quality domestic and developed international debt markets are south of -0.3. Ok, correlations have been lower in the past, but they have also been higher. In fact the average correlation of US stocks and bonds over annual holding periods is indistinguishable from zero.
Is it a free lunch? No, not given the low interest rates on bonds today, but compared to the costs of using other forms of portfolio protection plain old bonds seem to offer the lowest opportunity cost with the lowest execution risk. The way we look at it is that the below normal yields are the premium you must pay to protect your portfolio.
Let’s look at a simple case using a portfolio composed 60% of the S&P 500 and 40% of the Barclays Aggregate. We are assuming that stocks have a volatility of 16% and bonds of 6% (these are currently our long-term normalized estimates).
The benefits depend on the volatility of stocks and bonds as well as their degree of co-movement. Historically, the correlation between stocks and bonds in the US has been about zero. Under such a scenario, the 60/40 portfolio would have a volatility of 9.9%.
There have been long periods of time, however, when the correlation has actually been positive. Stocks and bonds moving in the same direction either up or down. Let’s assume a modest correlation of 0.2. Under such a scenario the diversification benefits still accrue but at a lower rate. The 60/40 mix now exhibits a volatility of 10.4%.
What happens when the correlation between US stocks and bonds is actually negative? The simple answer is that the diversification benefits are significantly enhanced. Let’s assume a correlation of -0.2. This estimate is in line with our current estimate from our proprietary multi-asset class model. Now the 60/40 portfolio has a volatility of 9.4%, a full point lower than the earlier case.
Why stop there? Let’s push the envelope and assume a stock/bond correlation of -0.6. Quite dramatic for sure but not out-of-bounds from previous capital market experience. Now the benefits are further enhanced with the portfolio exhibiting a volatility of 8.4%
The role of bonds should be seen from the perspective of the total package of benefits. Historically, the role of fixed income has been income generation, but in today’s environment investors should focus as well on the diversification benefits created by mixing bonds with equity-like assets.
Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets. Incorporating bonds into the mix will be especially important in risk on/off markets such as those we expect to prevail over the next few years.
Let us hope that the marriage between stocks and bonds which at times has been a bit awkward remains beneficial as we transition into a low capital market return environment.
Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC
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