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Diversification Strikes Back In 2016

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Diversification Strikes Back In 2016 by Jeffrey L. Knight – Columbia Threadneedle Investments

After taking a hit in 2015, diversification proved its worth again in the first half of 2016. But a closer look at the catalysts for the recent success reminds us that the benefits of diversification have limits — and analysis of today’s market conditions suggests that investors should resist the urge to become complacent in their diversification strategy.

With 2016 half over, we advocates of diversification can feel good again. Although the last six months have been tumultuous, with no real progress having been made by global equity markets, well-diversified investors have reached the halfway point of the year with favorable results. Not only have diversified, global portfolios delivered a less volatile first half than an all-equity portfolio, but they have also delivered a higher return. After a year like 2015, when it seemed like a more diversified portfolio translated to worse results, we are delighted, though not surprised, to see diversification providing a strong benefit to investors again.

Diversification has provided more efficient results year to date

Past performance does not guarantee future results. It is not possible to invest directly in an index.
Source: Columbia Management Investment Advisers, LLC for 12/31/15-6/30/16.

Breaking down the drivers of diversification’s recent success

The news is not all good as we pass the halfway mark of 2016. When we examine the two main reasons why diversification is working, we find reasons to question the durability of each. As we contemplate investment strategy for the third quarter and beyond, we must acknowledge that the benefits of diversification do have limits. If we reach these limits, we must consider other techniques to deliver the attributes that we routinely expect diversification to supply. As we discuss below, when we analyze today’s financial market conditions, we detect that these limits may not be far off.

The effectiveness of diversification as an investment strategy during the first half of 2016 can be traced to two significant features of financial market performance over this period. The first has been the reliable power of interest-rate-sensitive bonds to offset equity market losses. For example, during the first six weeks of this year, the S&P 500 Index declined by over 8%, while the Bank of America Merrill Lynch 10-Year Treasury Index gained more than 4%. While a portfolio invested across stocks and bonds would likely have suffered a drawdown over this period, the magnitude of that drawdown would have been much less severe, and therefore much easier to recover from, than that of stocks alone. The arithmetic of compounding favors lower volatility of returns.

The second driver is the excellent performance of some of last year’s most downtrodden asset classes. For example, the year-to-date return (as of June 30, 2016) for the Goldman Sachs Commodity Index was 9.9%, easily outpacing the 1.2% return of the MSCI ACWI, which represents global equities. Likewise, the year-to-date return of emerging market equities, as measured by the MSCI Emerging Markets Equity Index, has outperformed both the U.S. market and developed markets outside of the United States. Interestingly, these high-performing asset classes are among the most adversely affected by strength in the U.S. dollar exchange rate. Not coincidentally, the USD weakened overall during the first half of 2016.

Cracks in the success story: Diversified investors face potential threats

The month of June ended with investors focused on the recent referendum in the United Kingdom indicating that citizens favored a withdrawal from the European Union. Volatility across equity, bond and currency markets spiked in the aftermath of this result. The entire episode has once again showcased the benefits of diversification. However, it may also have accelerated the demise of efficacy for the very two drivers that have flattered performance for diversified investors so far this year. Despite the ups and downs we have seen across many markets after the vote, the two discernable effects that have endured are a decline in interest rates and the weakness of the British pound and the euro. We explain below why each of these effects may bring challenges to diversified investors in the months ahead.

First, bond yields around the world were already low before the U.K. referendum, and they have dropped precipitously since. The yield on 10-year U.S. Treasury bonds, for example, has fallen from 1.75% before the vote to below 1.4% (as of July 8). Even more remarkably, the yield on 10-year Gilts in the U.K. has fallen by nearly half, from 1.37% to below 0.8% as of the same date. These moves have been mirrored by long-duration bonds worldwide, and the strength of these bond returns has in turn helped portfolios with adequate bond exposure not only hold their value during the recent market turbulence but indeed deliver solid gains overall. We wonder, however, even in this age of negative bond yields, how much longer this performance can continue. While positioning for a low-rate environment remains sensible, we think the current level of yields more than reflects the low-growth and low-inflation realities of today’s global economy. If we are correct, the implications are important for diversified investors to understand. Specifically, in a scenario of ongoing fundamental weakness, the incremental response from bonds may be positive but weak, while the response from risk assets could be more severe to the downside. In this scenario, the diversification benefit from long-duration bonds could be inadequate to stabilize portfolios. On the other hand, in an upside scenario we can imagine bond yields rising back toward levels in place before the U.K. referendum. In such a scenario, long-rate exposure could materially offset the gains earned by risk assets. Under these conditions, we believe our diversification strategy must evolve and adapt. Simply put, we think a static balanced portfolio strategy will be inferior to a dynamic strategy that reduces risk assets if fundamental conditions deteriorate and reduces safe assets, especially long-duration bonds, if conditions improve.

Second, the uncertainty created by the U.K. referendum may affect the solid performance of assets like emerging market equities and commodities, which have benefited from a weaker U.S. dollar exchange rate in 2016. Currency markets have made even larger adjustments than bond markets in the aftermath of the vote, and the prospect of U.S. dollar strength, recently diffused by a more dovish Fed, may well assert itself again. So far, the response of the U.S. dollar has been mild, but the average exchange rate mixes the dollar’s material strength against the pound and the euro with its weakness against the yen. Should Japanese policymakers pursue actions that weaken the yen, the dollar will have nowhere to go but up. Such an environment could bring about a relapse of the frustrating conditions that global portfolios endured during 2014 and 2015, where losses from unhedged international holdings as well as weak performance from dollar-sensitive assets subdued the returns of broadly diversified global portfolios. For now, we think global portfolios held by USD investors should be significantly hedged in their currency exposure. In addition, investors should pay close attention to the strength of the dollar, for if the dollar were to once again challenge its recent highs, we would expect a negative response from emerging stock markets, commodity prices, credit markets and U.S. corporate earnings.

Diversification still gets our vote, along with three tools to help endure the current environment

We continue to stress the timeless benefits of diversification for investors concerned with managing the tradeoff between risk and return in their portfolios. We can now point to the first half of 2016 as another case study in the power of diversification to reduce portfolio volatility while exposing investors to numerous sources of return. Yet in the current investment environment we have also observed that these benefits can be diminished by rising correlations or diminished prospective returns. Therefore we emphasize that even well-diversified investors should not become complacent with their portfolios, and we believe that over the balance of the year investors may benefit from supplementing their basic diversification with three additional tools:

  1. We believe that foreign currency hedging makes sense as weakness in the pound, the euro and potentially the Japanese yen could erode returns from investments denominated in those currencies.
  2. We believe investments besides bonds that can diversify equity risk should be incorporated to expand the downside resilience of portfolios. Such investments may include liquid alternatives screened for equity correlation, or explicit equity hedges.
  3. We believe that active de-risking may make sense if conditions for risky assets deteriorate.

Volatility is calculated using weekly return data. The risk parity proxy is constructed as 30% MSCI All Country World Index, 100% Barclays Global Aggregate Bond Index, 10% Barclays U.S. Corporate High Yield Index and 10% Bloomberg Commodities Index.

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