Diversification: Beyond "Pain" Vanilla

Diversification: Beyond "Pain" Vanilla

Recent volatility is forcing investors to question whether the diversification measures they now have in place will truly hold up going forward.

October 2018 tested investors’ resolve and begs the question of whether the diversification measures they have integrated into their portfolio construction, both at the asset allocation and underlying equity level, will truly hold up amid what we believe are likely to be volatile times ahead.

The traditional 60% equity/40% fixed income portfolio realized its worst monthly loss in October, down -4.42% since May 2010 as both equities and bonds depreciated. Over the last twenty years, the 60/40 portfolio has only suffered a worse monthly decline in 8 of the last 240 months, less than 3% of the time.

October Marks Worst Performance Since May 2010 

Traditional 60/40 Stock and Bond Portfolio: Monthly Performance Post Global Financial Crisis  

 

Source: Standard & Poor’s, Barclays Indices, eVestment. Reflects hypothetical portfolio composed of 60% stocks and 40% fixed income, wtih stocks represented by the S&P 500 Index and fixed income represented by the US Barclays Aggregate Index, with quarterly rebalancing back to 60/40 allocation target.  Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 

Stocks and bonds have historically realized a negative correlation; however since the Global Financial Crisis (“GFC”) correlations have gradually climbed, as both bonds and equities have risen in tandem. As the US begins to move from a quantitative easing to tightening interest rate environment, volatility has started to ripple through markets -- generating losses in both stocks and bonds and diluting potential diversification benefits. This leaves many investors to consider the portfolio implications, as the long-term yin to yang of two complementary asset classes begins to fray.

Rising Equity-Bond Correlations

S&P 500 vs U.S. Aggregate Index

Source: Standard & Poor's, Barclays, eVestment.  Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 

Furthermore, amid a trending and narrowly driven market -- such as the one experienced post-GFC (global financial crisis) -- many investors may find their portfolios have increased exposure to Growth/Momentum factors and underlying consumer-facing technology companies (housed within Consumer Discretionary, Telecommunication Services and Information Technology sectors). Taking on unintended risks increase a portfolio’s vulnerability to pronounced drawdowns as trends reverse. Factors such as High Dividend and Minimum Volatility and sector such as Utilities and Consumer Staples, which have lagged since the GFC, exhibited a significantly lower beta to the market and realized a lower standard deviation versus their cyclical counterparts.

Factor and Sector Risks in October

Volatility vs Beta to US Stocks

Source: Standard & Poor’s, eVestment and Bloomberg. Factors represented by equivalent MSCI factor Indices and Sectors represented by S&P 500 Index GICs, Level 1 Classification. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. Figures reflect period of Oct. 1 thorugh October 31. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 

As a result, High Dividend and Minimum Volatility drew down roughly 60% less than Growth and Momentum factor stocks during October, while Utilities and Consumer Staples were the only sectors which realized positive returns for the month.

As such, many investors have begun looking beyond the traditional 60/40 portfolio on two levels. At the asset allocation level, there is the potential to add uncorrelated return sources found within the alternatives sleeve, such as a Market Neutral strategy. And within the underlying equity sleeve, investors are examining the implications of the increasing beta and volatility associated with certain factor and sector exposures.

 

Note: Diversification and asset allocation strategies do not assure a profit or protect against market loss.

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