By Wayne Yi, CFA
We are staunch believers in diversified investing and asset allocation as a critical element of portfolio construction. Before you roll your eyes and start referring to me as “Captain Obvious,” entertain me as I expand on why it’s so important and the potential risks when diversification is ignored.
Diversification isn’t the scaredy cat’s way of hedging your bets by spreading investments across several low conviction ideas and then hoping more succeed than fail. Rather, it is a tool for appreciating how different kinds of risk across various investment strategies and asset types interact with each other, and knowing how to combine them so that an investor can increase their conviction for an expected return and reduce uncertainty in the portfolio. By knowing the underlying risk of an investment and its behavior to movements in other asset classes, we seek to gain greater confidence in achieving targeted returns than if one were to invest in a single asset or strategy alone.
Let’s take a basic stock and bond portfolio. Equities (via the S&P500) have averaged about 11.7% in annualized returns since 1984 with a volatility of about 14.7%. Bonds (via the BB US Aggregate Bond Index), on the other hand, have annualized at about 7.1% in returns with only 4.2% in volatility. While stocks have generated more returns than bonds over time, there is significant risk of out- and under-performance to the average in any given year. Alternatively, bond returns are lower than stocks, but investors could expect consistent positive performance with a relatively high degree of certainty in that time period.
The beauty of combining the two asset classes, like all relationships, is in how they behave when they are paired together. The risk of owning a 50/50 stock/bond portfolio is not simply the average of the standard deviations of the two assets, which would be 9.5% in this case. Rather another component, called “correlation,” comes into play. Correlation is essentially the measure of how much similarity in movement there is between the two assets. Put even more simply, how much do bonds “zig” when stocks “zig” or do they “zag.” The greater the zig-zag effect, or lower the correlation, the greater the diversification benefit. Alternatively, if correlations are high, there is no diversification benefit to owning both positions.
The historical correlation between stocks and bonds over the same time period has been 15% out of 100, which is very low. By incorporating correlation into our diversification strategy, volatility for the portfolio is reduced to 7.9% from the 9.5% simple average. In our 50/50 stock/bond portfolio, we can achieve 80% of the average return of a stock-only portfolio with only 54% of the risk. Ultimately, diversification achieved from combining lower-correlation assets can support high quality returns for lower risk than owning the assets in isolation
The Year of the Zig-Zig
So why did I spend a page on portfolio theory? Because over a long period, diversification has been effective. In 2018, the S&P500 lost over 4% and the Barclays Agg was ever so slightly in the black. This relationship is expressed to an even greater degree when looking at the fourth quarter in isolation, where equities lost over 13% while bonds were up 1.6%. In 2008, equities lost 37% while bonds returned over 5%. And when equities lost over 40% between 2000 and 2002, bond gains approached 30%.
Source: Barclays, MQS Research
On the flip side, stocks typically rally when bond yields rise. However, this year has been a different story, as the 10-year Treasury has gone from 2.6% down to 2.0% by the end of June (a strong positive move for bonds), while the S&P500 also rallied towards 3000. A technical recovery from an oversold equity market in 4Q18, coupled with a very dovish monetary policy, staunchly low inflation and still positive economic fundamentals, has allowed for both assets to perform strongly this year.
The overriding factor, that has driven this market move, has been the dramatic course-correction of the Fed. After stepping back from his hawkish stance earlier in the year, Chairman Powell became even more dovish, messaging that the Fed would do whatever it could to support the domestic economy amidst US-China trade tensions and broader international economic weakness. To be clear, the domestic economy seems to be on stable footing, but because of instability seen abroad, the Fed is seeking to vaccinate now to avoid possible contagion later. Central banks around the world were in agreement as the ECB, Bank of Japan, and others turned more accommodative. The Bank of China will also likely behave similarly.
GDP Growth is Slowing EverywhereSource: Barclays Capital
Rates are thus falling, but stocks are flying, as an easy monetary policy should extend the economic expansion. We don’t yet see obvious signs of a recession in the near future, but we recognize that the pace of growth is slower and general confidence is weaker. From a valuation perspective, equities are expensive and bond yields are not compelling. There is still over $12 trillion of debt in the world with negative yields, meaning you would lose money by owning these government-backed securities.
S&P500 Forward 12 Month P/E Source: FactSet
Global Negative Yielding Debt (in $Billions)Source: Deutsche Bank
Furthermore, referring back to our initial discussion around portfolio construction, assets moving in the same direction increase correlations and thus reduce the benefit of diversification, making it harder to rotate capital in either direction. While currently well-contained, an acceleration in inflation would negatively impact both stocks and bonds. Thus it seems as though “There Is No Alternative” to stocks if one were to seek investment returns beyond a few percent.
However, investors with the capacity to allocate to alternative strategies, such as hedge funds and private equity, can avail themselves to differentiated investments that can be meaningfully less correlated to long-only stock and bond strategies and potentially generate higher quality returns with less volatility in the current environment. One of the bigger benefits of hedge funds is their ability to bet against, or sell short, securities that seem over-priced to balance out their investments that are expected to appreciate. Additionally, hedge funds can traffic in segments of the market that are too small for their mutual fund peers, in order to uncover higher-returning opportunities. Finally, by taking advantage of longer-term investor capital, hedge fund strategies can be buyers of compelling situations where more liquid vehicles may have to be sellers at low prices to fund redemptions. While the hedge fund universe is large, there are several strategies and investment managers that we have allocated to that have delivered returns better than fixed income markets with half the correlation and volatility of equities.
Investors with long-term capital can enhance their return expectations through participation in private equity vehicles, where investment managers seek out unique assets, businesses, or lending opportunities that are not readily available to the broader market. Acquisitions typically occur below their public market peers, and through active engagement on a value-creation program, managers can generate multiples of return on their initial investment and in excess of public market averages.
We find these alternative strategies to be accretive to portfolios today, reducing the sensitivity to stock valuations and bond spreads, yet still offering high-quality returns for patient capital. With equity markets returning almost 20% in the first half of this year, and the Fed on a path of another easing cycle, we recommend a rotation into alternatives to diversify and reduce the risk in traditional portfolios.
Outlook and Asset Allocation
EQUITIES: CHANGE TO MODEST UNDERWEIGHT
Equities continued to build on the first quarter rally to end the first half of 2019 up almost 20%, as measured by the S&P500. If we were to extrapolate that performance, 2019 would easily outpace the significant returns stocks delivered in 2013 (+32%) and 2017 (+21%). However, we all know that past performance is not an indicator of future results. Stable but slowing macro fundamentals, with limited catalysts for further material upside in the near-term warrant a more defensive posture. We continue to rotate into higher quality (strong margins, low financial leverage), large cap, domestically oriented businesses and are underweight developed international and emerging markets given greater economic weakness and political uncertainty in these regions. As we are closer to the end of the business cycle than we are to the beginning, we expect more frequent bouts of volatility in equities and thus find returns to come with greater risk. We believe a Value and “Quality” tilt will be more resilient to market weakness. We recommend investors capitalize on the strong market run and reposition to a modest underweight to stocks.
FIXED INCOME: TARGETWEIGHT
Rates are expected to continue to move lower over the course of this year. While the return opportunity is limited from bonds, they do serve as a counterbalance to equities and should protect on a stock market sell-off. We have modestly extended duration, but still remain shorter relative to benchmarks given the lack of additional yield. We are constructive on municipals for tax-sensitive investors. We remain selective with credit risk and thus have limited exposure to traditional high yield bonds and loans, and instead have opted for structural and liquidity arbitrage options to enhance returns.
LIQUID ALTERNATIVES: OVERWEIGHT
We are constructive on hedge funds in the current investment environment. We remain selective on long/short equity managers broadly as the ability to generate consistent excess returns is very difficult. However, we retain a select group of funds in this strategy that we expect to achieve that high hurdle and can be a substitute to the long-only equity risk. Arbitrage, idiosyncratic credit, and un-correlated asset strategies can generate strong, consistent returns ahead of fixed income and without rate sensitivity in a directionless market. Furthermore, increased market volatility can potentially expand the investment opportunity for these strategies as they have modestly longer liquidity terms versus their long-only peers.
ILLIQUID ALTERNATIVES: OVERWEIGHT
We are overweight illiquid alternatives given their longer investment periods and ability to extract value through active engagement with their portfolio companies. We recognize that valuations in private equity have also risen, but to a lesser extent in the lower middle market space. Furthermore, institutionalizing operations and strategic acquisitions can improve margins and offset some of the purchase premiums. Over an investment cycle, private equity investments should generate materially stronger returns over public markets in exchange for longer holding periods.
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