Nobel Prize winner Harry Markowitz once famously referred to diversification as “the only free lunch in finance.” His message was simple and timeless: By allocating capital across a mix of assets, clients can increase the probability of realizing their targeted return over time, with an acceptable level of portfolio volatility.
The shifting value of broad diversification
One of the many challenges for investors is that the benefit of diversification does not really have a constant value. Multi-asset, multi-strategy hedge funds can play a pivotal role in achieving positive results for clients, though there have certainly been periods when diversification could be structured without the benefit of alternative investments. The decade following the Great Financial Crisis is a case-in-point regarding how investors achieved sufficient diversification somewhat simplistically, through a basic “set it and forget it” allocation to public equities and traditional fixed income.
From March 2009 through year-end 2017, for example, $1 million invested in the S&P 500 Index grew to $4.4 million. During that period, fixed income, as measured by the Bloomberg Barclays U.S. Aggregate Bond Index, provided investors with an annualized return of +4% without ever experiencing a loss of -4%, so the return-generating and capital-protecting components of a portfolio were readily available through a stock-bond allocation. But what about the final ingredient of sound portfolio construction: diversification? Did investors achieve high returns, capital protection, AND portfolio diversification through a standard asset allocation?
The answer is a resounding yes. When looking at the 11 months during that time period when the S&P 500 Index declined by at least -3%, fixed income was positive 10 times; only August 2015 broke the trend with a negative return for bonds of just 14 basis points. The average S&P performance for these “negative equity” months was approximately -5%, compared to an average gain of +1.2% for fixed income (Exhibit 1, left-hand side).
Over the past few years, however, something has fundamentally changed with respect to the “negative correlation” between stocks and bonds. Since 2018, the S&P 500 Index has had seven months with losses exceeding -3%. However, bonds were positive just three times – and negative four times – as shown on the right-hand side of Exhibit 1 (and again, in October, when the S&P fell by nearly 3%, fixed income failed to protect as both bonds and stocks declined).
Not only has the correlation changed, it has shifted along with an increase in the volatility of stocks: The average S&P 500 Index decline has been -7.2% over the trailing three years. Higher equity risk coinciding with a declining benefit from the “flight-to-quality” that bonds have historically offered creates structural challenges for investors in the current environment. Whether this shift is cyclical or secular is another key consideration.
Looking at that 2009-2017 period, we know that the long-term valuation of the S&P 500 was trading at a 20-year low coming out of the economic crisis, with a cyclically adjusted price/earnings ratio (CAPE) of 15x. And with Treasuries yielding north of 3%, there was “room to move” in terms of both stock and bond price appreciation. Fast forward to today, we see that the CAPE ratio for stocks has more than doubled to 32x, reflecting the “richest” valuation for equities since the late 1990s, while the current yield on “safe” bonds has fallen to less than 0.7%. With capital market assumptions for stock and bond performance in the low- to mid-single digits, along with an expectation for continually higher volatility and a potentially deteriorating relationship for equities and fixed income, the need for accessing diversified sources of return has rarely been higher.
For many clients, and some advisors, their own investing history dates back two decades or so. And since 2000, the relationship between stocks and bonds has been consistently negative, as shown in Exhibit 2. Reviewing this correlation over a longer period suggests that traditional assets have been positively correlated for significant periods of time, and that a false sense of security from stock/bond diversification may be dangerously misplaced. If the past three years are an indication, we may have already entered an environment when bonds will not be the automatic safeguard against declines in the stock market, as many have come to expect.
Exhibit 2: Correlation Between S&P 500 and 10-year U.S. Treasury Returns
Source: Bloomberg, as of September 30, 2020. Correlation based on daily returns using exponential weighting with a 2-year half-life. For illustrative purposes only. Past performance is not indicative of future results.
Multi-asset, multi-strategy portfolios are built for this environment
If the relationship between stocks and bonds has indeed shifted, at a time when returns may be harder to come by and volatility is elevated, how can clients avoid missing out on the diversification “free lunch” that helps drive performance while protecting against excess risk? Within hedge funds, the answer is clear: Diversified multi-asset, multi-strategy portfolios are purpose-built for this type of environment. Over the past few years, select funds have clearly demonstrated an ability to protect capital in periods like the fourth quarter 2018 and the first quarter 2020, while the absolute returns have steadily increased on the back of a correlation breakdown and recent market dislocation.
These types of diversified funds are highly distinct from one another, and hard to lump into a single strategy bucket. Some are among the largest, most established firms in the industry, with track records spanning decades and a proven ability to navigate uncertain market conditions with demonstrated success. Other funds are “right-sized” to consistently access non-beta sources of return in less efficient arbitrage strategies. And some may be considered “emerging” given their comparatively smaller pools of capital, but are managed by experienced practitioners with personal capital invested alongside their limited partners, and an ability to tactically allocate capital as opportunities and risks shift across global equity and credit markets.
Analyzing markets today, the value of diversification is clearly on a cyclical upswing. Historically, these shifting asset class cycles often last for years. Investors are struggling with reduced return expectations from stocks, near-zero yields in bonds, and a far less robust portfolio from just a traditional asset allocation blend. The diversified multi-asset fund model, with a record of delivering consistent returns away from the directional or relational dependency on equities and fixed income, is having its day in the sun once again. Ensuring sufficient portfolio diversification has shifted from a nice-to-have to a need-to-have in the current, and likely future, market environment.
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