Clik here to view.
Equity risk will inevitably play some role in a portfolio, depending on the portfolio’s goals. That makes sense when you consider that equities represent exposure to the productive economy. Over a long time horizon, that exposure provides the kinds of returns that most investors need to accomplish their goals. But, what about when you expect the economy to falter or, worse, enter a period of decline? Is it enough to endure the paper losses in your portfolio, knowing that over time equities pay a premium for exactly that risk? Will shifting some equity risk to bonds provide protection in a down market? Are there alternative risks to consider when one wants to position a portfolio more defensively?
Let’s examine how bonds might be expected to protect a portfolio in down markets and look at the current state of the U.S. economy and the broader global economy to consider whether alternative risks might not be prudent in a post-financial crisis world to accomplish the type of diversification that every fiduciary is bound to deliver.
While bonds can be expected to do a good job protecting a portfolio in down markets, their returns will be extremely challenged. Alternative risks appear to be useful in this environment with their ability to deliver diversification with potentially better returns. Like all things, there are important risks in alternative strategies that fiduciaries need to be mindful of. There are lots of alternative risks (not all of which produce reliable or material returns). And, there are lots of ways to access alternative risks (not all of which are designed to deliver the kinds of results we might be looking for). This article isn’t intended to provide a complete answer to these questions. Instead, it’s geared to offer some important generalizations for fiduciaries to consider when thinking about alternative risks in their portfolios.
The Level Factor
Bonds are the traditional “alternative risk” in most portfolios. At their most basic level, bonds earn returns for making long-term financing commitments (the so-called “Level Factor”). An investor should expect to earn a premium for owning a 10-year bond over owning a series of 10 1-year bonds. The Level Factor premium is driven primarily by monetary policy (which is, in turn, driven by expectations about inflation and growth).
When markets expect inflation, the Level Factor returns should be higher. Inflation will erode the value of the fixed payments on bonds (and therefore lower the price someone is willing to pay for those future payments). Markets will also expect the central bank to intervene to stem the inflationary pressures, usually by raising rates on shorter dated bonds that should transmit across the yield curve.
Higher returns on the Level Factor, though, typically presage lower equity returns. Usually, inflation expectations mean that the economy is humming along and are generally good for equity returns. But, inflation will ultimately hurt the consumer, and central bank intervention will make financing more expensive for businesses. Investors might also respond to higher returns on Level Risk by shifting some of their allocations from equities to bonds, putting downward pressure on stock prices. On balance, then, equity returns tend to suffer when returns on the Level Factor are higher.
Conversely, when markets expect an economic contraction, Level Factor returns should be lower. The future fixed payments on bonds will be more valuable to investors, who'll bid up the price of bonds (thus lowering long-term rates). Markets will also expect the central bank to intervene to promote growth, usually by cutting rates on shorter dated bonds that should transmit across the yield curve.
As you can probably predict by now, lower returns for the Level Factor tend to presage higher equity returns. An economic contraction (and the corresponding central bank intervention to stimulate the economy by lowering rates) ultimately helps the consumer and lowers the cost of financing for businesses. Therefore, investors will expect expanding growth in bottom lines and drive up the price of stocks. Investors might also shift some of their holdings from the now lower returning bonds to the higher returns of equities, further increasing the value of equities.
How It's Worked
So, how has this really worked in practice? Well, it hasn’t been nearly as consistent as economic theory would have predicted. Certainly, since the late 1990s, there’s been a persistent negative correlation between stocks and bonds, as one might expect. But, this is by no means the entire story. From the 1960s until the 1990s, there was a positive correlation between stocks and bonds. For example, correlations between the S&P 500 and 10-year Treasury returns ranged from 15% in the 1960s to 32% in the 1990s.
What accounts for the difference? For the early part of this time period, there were periodically expectations of higher inflation and little faith in the Fed’s ability to manage it. Inflation expectations and monetary policy “surprises” tend to drive asset prices in the same direction. For example, high expected inflation and little confidence in the Fed can lead investors to expect long-term rates to move higher than the expected increase in prices. The resulting higher real rates would reduce economic activity, and returns for both the Level Factor and equities would fall.
But, since the late 1990s, the Fed has shown itself capable of maintaining control over inflation. It’s also made itself more transparent, leading to fewer monetary “surprises.” When inflation expectations and policy surprises are less important, shifts in growth prospects and risk preferences predominate asset pricing, leading to the negative relationship economic theory suggests. Expected growth not only drives equity prices higher but also tends to drive rates higher (and thus reduce returns on bonds).
Future Expectations
So, what can we expect in the coming years? One way to speculate on the future is to look to the very recent past. Even though the Fed has maintained its ability to manage inflation and remain transparent over the last nine years (and therefore the correlation between stocks and bonds has been negative), there were two years when that relationship flipped. In 2013, for example, during the taper tantrum,1 the correlation between stocks and bonds was 0.13. Likewise, speculation about Fed tightening in 2014 led the correlation between stocks and bonds to be 0.12. Similarly in 2017, with focus on global central bank tightening, correlations between stocks and bonds was only -0.02 (this makes bond returns essentially independent of stock returns).
To be sure, bonds rarely approach anything like perfect correlation with stocks. Instead, they’ve consistently been diversifiers in portfolios, albeit with greater or lesser effect. We should expect a Fed that continues to take seriously its management of inflation and to remain fairly transparent. So on balance, we should expect to see modestly negative correlations between equity and bond returns, as expectations about growth and risk appetite drive asset prices.
And, what about the absolute levels of returns of bonds? Returns on rocks are utterly independent from returns on equities, but a fiduciary wouldn’t want to own rocks in her portfolio. Their returns are zero.
While not nearly as bad as rocks, 10-year Treasury bonds haven't provided much in returns. They earned essentially no return in the 1990s. Annual returns in the 2000s were 2%, and in the 2010s (so far) they’ve been 5%. Looking more closely at the last six years, however, we see that 10-year Treasuries have delivered positive returns only in 2014 (almost 20%) while 2013, 2015 and 2016 have been significantly negative (-31% to -43%). The years 2017 and 2018 were a modest -0.4% and -2.2%, respectively.
Growth expectations are declining globally, and risk appetite has fallen off significantly. If those continue to be the primary drivers of asset returns, we should expect to see very low bond returns. While bonds might be expected to continue to provide good diversification in portfolios, they’ll struggle maintaining their purchasing power. For many fiduciaries, when there’s annual spending from the portfolio, that’s an unhappy trade-off that will result in a declining real value of the portfolio. (See “Meeting Cash Flows With Lower Market Returns,” by Elizabeth K. Miller, in this issue, p. 61.)
Alternative Risks
Are there alternative risks that fiduciaries should consider?
Alternative risks are really investment strategies that seek to earn returns for owning risk factors that play only a minor role in a traditional asset class. To provide exposure to alternative risks, managers trade traditional securities but use a combination of longs and shorts to isolate some risk factors over others. What risk factors are we talking about? The most typical alternative risks are carry, tail risk and illiquidity. Carry (or sometimes “non-directional risk”) is the return earned by betting on the spread between two similar risks while minimizing (or eliminating) most of the traditional risk. Tail risk is the degree to which an asset experiences extreme swings in returns. Tail risks are usually asymmetric (meaning they're more often losses than gains) so investors earn a return for bearing that risk. Sometimes tail risk is the result of leverage, other times, it’s the result of a trading strategy. And, illiquidity can earn a return, thus also acting as an alternative risk.
Too often, strategies that target one or more of these risks get lumped together by virtue of their structures and are called “hedge funds.” But, in fact, hedge funds aren’t themselves a single strategy. Rather, they’re many different strategies with very different characteristics. Among these alternative risk strategies, one can find certain styles that provide more diversification, higher absolute return (or both) compared to bonds.
Once a fiduciary identifies alternative risk strategies that might be appealing in portfolios, one must go one step further and identify the kinds of alternative risks to which the style provides exposure and whether they’re appropriate for the portfolio’s overall goals. For example, if a portfolio makes regular distributions, a strategy with more tail risk or a strategy whose trades are less liquid might not be appropriate. The need to liquidate an asset in a down market might make those risks simply not worth the marginal benefit of the better diversification or better absolute returns.
But, if a portfolio is large enough to cover regular distributions, allowing the fiduciary to ride out a down market, then exposure to one or more strategies providing exposure to these alternative risks might be a useful tool to provide better returns with the same (or better) diversification benefits as bonds.
Macro Strategies
Macro is one style that fiduciaries might consider as a possible substitute for some of the portfolio’s equity risk. Macro strategies trade relatively illiquid instruments in markets that are correlated with macroeconomic growth (like rates and currencies) but add leverage to boost returns. We should expect macro funds’ returns to be modestly correlated to equity returns and independent from bond returns. While their returns will move fairly consistently with equity returns, one wouldn’t expect the movements to be very similar, thus providing a degree of diversification. Macro funds should have more tail risk than equities, and their trades should be less liquid. They generally deliver modest returns with very low volatility.
By way of illustration only, let’s look at the Guggenheim Macro Opportunities Fund, a readily available exchange-traded fund (ETF). Since 2011, the fund’s returns have been very nearly independent of bonds (correlation of about 0.02 to a 3-year to 10-year Treasury Index ETF (ITE)) and moved pretty consistently (but not perfectly) with equity returns (correlation of 0.48 with an S&P 500 ETF (SPY)). The fund seems to have about twice as much in tail risk as equities do, and its trades seemed to be fairly illiquid (measured by its autocorrelation) at least compared to equities. Annual returns were 5% over that period (about a third of the return on U.S. equities) with volatility of about 3% (also about a third of U.S. equities). Because it lacks perfect correlation with equity markets, in down markets one might expect this strategy to be a good diversifier. In 2018, when the S&P 500 was down about 11%, the fund was flat.
Directional Long/Short
Another possible substitute for some equity exposure could be directional long/short. These strategies combine long and short positions in stocks with an expectation that one is overvalued compared to another (so-called “pair trades”) or when there’s a price discrepancy between two similar securities (so-called “statistical arbitrage”). One would expect these strategies’ returns to be fairly correlated to equities’ returns but roughly independent from bond returns. Their returns should be less correlated in market declines, and they should therefore be less volatile. They should have about the same tail risk as equities, and their trades should be at least as liquid.
By way of illustration only, let’s look at PIMCO’s ETF executing the strategy of a famous quantitative manager, Research Affiliates. Since 2015, the fund’s returns were nearly independent of 3-year to 10-year Treasuries (-0.06 correlation to ITE) and highly correlated to equities (0.70 correlation to SPY). The fund had as much tail risk as equities, and its trades seem to be at least as liquid as equities. Returns were 5.8% over the period (almost exactly 70% of SPY’s 8.3% return) with volatility of about 10% (again nearly 70% of SPY’s 14% volatility). But, because it's not perfectly correlated with equities, in down markets one might expect this strategy to be a good diversifier. In 2018, when the S&P 500 was down about 11%, the fund was up nearly 2%.
Managed Futures
Managed futures is another style that fiduciaries might consider as an alternative to bonds. These strategies trade in futures contracts (usually in commodities and equities markets). They often use sophisticated computer-driven trading algorithms to capture small price movements and focus on identifying short-term patterns. Naturally, they use a good bit of leverage to make returns more reasonable. One should expect managed futures funds’ returns to be nearly independent of stock returns and only mildly correlated to bond returns; that is, while their returns will often move in the same
general direction as bonds, one would not expect that to happen in down markets. Managed futures funds tend to have more tail risk than bonds (because of the leverage), but their trades tend not to be very illiquid. They should deliver modest returns with modest volatility.
By way of illustration only, let’s consider the LoCorr Long/Short Commodity Fund, another readily available ETF. Since 2012, the fund’s returns have been nearly independent of stock returns (0.07 correlation to SPY) and were only modestly correlated with 3-year to 10-year Treasuries (0.19 correlation to ITE). The fund had almost three times the tail risk as 3-year to 10-year Treasuries, but its trades seemed not to be illiquid (measured by autocorrelation) compared to bonds. Returns were 4.6% over the period with 12% volatility, compared to 1.2% return and 2.3% volatility for 3-year to 10-year Treasuries. In 2018, when 3-year to 10-year Treasuries earned 3.6%, the fund was up 7.6%.
Market Neutral
Another possible alternative to bonds with significant tail risk is market neutral. This strategy trades in equities using both long and short positions. But, in this strategy, the manager seeks to neutralize nearly all of the equity market risk. The trades tend to be mean reverting (that is, short term) with spreads that diminish over time. One would expect market neutral funds’ returns to be mildly negatively correlated to both stocks’ and bonds’ returns; that is, their returns should usually move in the opposite direction of stock and bond returns, but not always. They tend to have about as much tail risk as bonds, and their trades are about as liquid as bonds. Because they have negative correlations, these strategies have negative returns when markets are up but deliver much better returns in down equity markets.
By way of illustration only, one of the longest running market neutral ETFs is the Vanguard Market Neutral Fund. Since 1998, the fund’s returns have sometimes moved in the opposite direction from equity returns (-0.15 correlation to SPY) although they were nearly independent from equity returns in down markets (0.04 conditional correlation to SPY). Likewise, the fund’s returns sometimes moved in the opposite direction from bond returns (-0.14 correlation to ITE) although they were nearly independent in down markets (conditional correlation of 0.08 to ITE). The fund had about the same tail risk as bonds, and its trades are about as liquid as bonds. Returns were a modest 1.6% since 2007 with 6% volatility (compared to 3% return and 9% volatility for ITE). In a world in which bond returns feel challenged, this might be a useful alternative strategy.
Appropriate Alternatives
Expectations for U.S. growth have been declining, and many believe that we can expect (or already are in) a mild economic recession. Likewise, risk appetite has declined as investors try to divine the timing and depth of the next equity market decline and assess the myriad of global risks that threaten the world’s economies. Bonds, which have served as a good diversifier in portfolios for the last 20 years, should continue to play that role. But, the combination of the already low rates following the financial crisis and the expectation that the Fed will lower rates to help soften an economic decline, suggests to some that bond returns will be challenged and might not maintain purchasing power.
Alternative risks could be an appropriate substitute for some of a fiduciary’s equity and bond exposures.Alternative risks require careful consideration to identify exactly the scope of those risks. And, just because the risks seem to offer better diversification and/or returns than bonds, fiduciaries should be cautious to consider how those risks will play out in their portfolios.
—Arrow Wealth Advisory LLC does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Endnote
1. The “taper tantrum” refers to the surge in U.S. Treasury yields in 2013 when the Fed announced it would begin to gradually reduce its program of buying bonds. It was thought that the reduction in bond buying would lead to a collapse of prices (and increase in rate), and the market reacted accordingly.