Stocks, Bonds and Other Diversification Pairings at Risk: Steven Sears
Traditional investment portfolios that are diversified between stocks and bonds may not be as bombproof as many investors and advisors believe.
Inflation, barely a concern for the past decade, can interfere with bonds’ historical ability to moderate declines in stocks. And, as the 2008 financial crisis painfully illustrated, stocks, bonds and other asset classes can, unexpectedly, move in unison.
While theories of diversification have been debated by institutional investors and academics for years, two major investment management firms are publicly questioning the effectiveness of the primary framework used for portfolio allocations, citing recent economic signals.
PIMCO, the asset management giant with a fixed-income bent, is warning clients that rising inflation is on the horizon and may well disrupt the diversification benefits of the classic 60-40% stock-bond portfolio mix.
And investment analysts at T. Rowe Price recently asserted that diversification using a more sophisticated mix of assets can leave investors in the lurch.
“One of the most vexing problems in investment management is that diversification seems to disappear when investors need it the most,” Sebastien Page, the global head of T. Rowe Price’s ‘multi-asset’ division, and Robert Panariello, a quantitative analyst at the firm, noted in an abstract of their recent Financial Analysts Journal article titled ‘When Diversification Fails.’
“We surmise that many investors still do not fully appreciate the impact of extreme correlations on portfolio efficiency—in particular, on exposure to loss.”
During the 2008 global financial crisis, a portfolio diversified across U.S. stocks and bonds, international stocks, emerging market stocks, and real estate investment trusts, experienced correlation so extreme that the asset classes basically moved in unison downward.
Diversification failed so utterly that the portfolio unexpectedly underperformed even a simple 60%-40% U.S. stock-bonds portfolio by nine percentage points, the analysts found.
PIMCO product and investment strategists Bransby Whitton, Klaus Thuerbach, and Georgi Popov, meanwhile, are calling into question even the basic benefits of a traditional, conservative 60-40 stock-bond portfolio mix.
In a November 2018 essay distributed by the firm titled “Preparing Portfolios for Resilience Against Inflation Surprises,” they warn that the risks of such core diversification are not widely understood.
The correlation between stocks and bonds is hard to estimate, and the relationship can change with great ferocity when macroeconomic conditions change. They synch more closely when inflation is high or rising, a condition that the authors see as imminent as the Federal Reserve and other central banks begin normalizing post-financial crisis monetary policy.
Advisors may have been easily lulled into relying on the 60-40 mix because inflation has been low for decades and the diversification has produced admirable risk-adjusted returns. But the times they are a changing, and the results can be consequential, especially for investors who are retired, or near retirement.
“Stock-bond correlations tend to increase when inflation is either high or rising,” the Pimco strategists write. “This could be a big problem for investors worried about inflation because positive correlations essentially mean less effective portfolio diversification.”
Inflation, as measured by the Consumer Price Index, was near zero in 2015 but last year was 2.5%, reflecting international trade tensions, higher consumer spending, a tight labor market and the growth effects of President Trump’s tax cuts. That’s hardly out of the norm, but both the T. Rowe and Pimco authors are signaling concern.
When the Federal Reserve reverses the easy-money policies that have been in place since 2008, and which have artificially inflated stock and bond markets, the financial markets may convulse, the T. Rowe’s Page and Panariello warn.
“The ‘taper tantrum’ of 2013, when Ben Bernanke first mentioned the idea of reducing or ‘tapering’ the Fed’s stimulus, provides a good example,” they write. “It affected stocks and bonds negatively at the same time.”
When inflation and rates drive market volatility more than fundamental business cycles and risk appetite—as occurred through much of the 1970s and 1980s—stocks and bond correlation often turns positive, Page and Panariello wrote.
To be sure, PIMCO expects inflation this year of 2% to 2.5%, a still moderate rise that reflects central bank trepidation about hitting the brakes on growth. But many institutional investors and banks are beginning to adjust their portfolios to prepare for correlation drift.
What should advisors do? The Pimco product strategists suggest moving investors to “real” assets, such as TIPS (Treasury Inflation-Protected Securities, sovereign inflation-linked bonds, commodities and REITs.
Such calls have been made prematurely, of course, in recent years as inflation stayed in check and equities rose. But it’s a delicate equilibrium.
Another alternative for insulating client portfolios against inflation and rising rates may be some core derivatives plays. Some sophisticated investors I know are bearishly buying put options on the S&P 500 index and/or sectors, or buying call options on the CBOE Volatility Index (VIX) in case the stock market tumbles.
The key is identifying risks to get ahead of the market and of the client behavioral issues that always rise when the market swoon occurs.
—Steven M. Sears is chief investment officer of StratiFi Technologies, a portfolio risk management software firm, and an investment columnist.