Build a More Diversified and Resilient Equity Portfolio

Historical correlations between equities and selected asset classes, explained by Mark Cintolo.

Treasuries did their job in Q1 2020, earning 8% while equities suffered deep losses, providing needed diversification and liquidity for rebalancing opportunities. Long duration (10+ year) Treasuries fared even better, returning 21%.1 But that might not happen again in the next dip. With Treasury yields near all-time lows, investors increasingly show signs of favoring the safety and liquidity of cash over US duration. If duration doesn’t provide protection in the next crisis, what will?

We have grown accustomed to duration providing downside protection against equity losses, but it hasn’t always been that way. For most of history, including the 1990s, equities and Treasuries had a slight positive correlation. In higher interest rate environments, a flight to quality did not require investors to extend out on the yield curve to earn an acceptable return. For example, in the aftermath of the September 11, 2001 attacks, short-term T-Bills saw the greatest drop in yields, while the 10-year Treasury barely budged.

Figure 1 plots the monthly returns of the S&P 500® vs. monthly returns of 10-year Treasury bonds since 1991. While the negative correlation between equity returns and bond yields generally holds over time, 48% of all negative equity months were negative returning months for Treasuries as well. Since 2000, the diversification story has been better, but some of the largest failures occurred during more recent drawdowns: the Q4 2018 selloff, the 2013 Taper Tantrum, and the 2008–09 global financial crisis. For the GFC, duration provided valuable protection in November 2008, but not in the months before or after.

Figure 1 – The Diversification Power of 10-Year Treasuries Is Not Absolute
WEBART173 0420 Chart 1
Source: Natixis Portfolio Clarity®, FactSet
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

What Else Works Under Pressure?
What can we learn from relative asset class performance in those periods? Are there other asset allocation decisions that complemented duration exposure in these rare but painful environments?

Good: Cash and short duration government bonds. Cash has a more reliable 0 correlation to equities across market environments. Shorter duration government bonds help provide higher returns than cash with less sensitivity to higher interest rates than longer duration bonds. Having some exposure to the short end of the yield curve also protects against the type of yield curve steepening that often occurs in more sustained drawdowns. In particular, October 2008 saw short-term bonds return +1% compared to -1% for 10-year Treasuries (Figure 2).

Figure 2 – S&P 500® vs. Short-Duration Treasuries
WEBART173 0420 Chart 2
Source: Natixis Portfolio Clarity®, FactSet
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

Bad: TIPS and commodities have not provided strong diversification (Figures 3 and 4). While massive stimulus packages may have driven concerns about long-term inflation, this has not historically led to meaningful increases in CPI, or higher prices for a broad basket of commodities. Conversely, in some of the environments where oil prices have climbed higher, equity returns have been strong and Treasury diversification has worked quite well.

Figure 3 – S&P 500® vs. TIPS
WEBART173 0420 Chart 3
Source: Natixis Portfolio Clarity®, FactSet
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

Figure 4 – S&P 500® vs. Commodities
WEBART173 0420 Chart 4
Source: Natixis Portfolio Clarity®, FactSet
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

Good: Gold. Unlike commodities, gold rose sharply in the early days of the global financial crisis before gradually giving back all of its gains in October 2008. So while the performance for that month appears sharply negative, the two-month return was only modestly negative. Gold began climbing again in November 2008 and continued to rise in early 2009 when equities continued to fall and Treasury yields rose. Gold did fall during the Taper Tantrum, but provided good protection in Q4 2018 (Figure 5).

Figure 5 – S&P 500® vs. Gold
WEBART173 0420 Chart 5
Source: Natixis Portfolio Clarity®, FactSet
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

Bad: Foreign currency. As with Treasuries, investors have shown a preference for the US dollar in times of market stress. Despite higher Treasury yields, the US dollar strengthened in all environments above. Foreign currency exposure exacerbated non-US equity losses (Figure 6).

Figure 6 – S&P 500® vs. FX
WEBART173 0420 Chart 6
Source: Natixis Portfolio Clarity®, Federal Reserve Bank of St. Louis
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.

Good: Active management. Market stress leads to greater dislocations, creating winners and losers across equities and corporate bonds. While passive strategies as a whole fared quite well throughout the relatively quiet 2010s, some of the bright spots for active strategies occurred when these drawdowns took place and risk management became paramount. Active management posted strong results across US equity, non-US equity, and credit categories in all periods (Figure 7).

Figure 7 – Percentage of Actively Managed Funds Outperforming Benchmark Index
Asset Category 10/2008 1/2009 2/2009 6/2013 10/2018
US Large Cap
49%
72%
74%
45%
36%
US Small Cap
55%
74%
78%
57%
55%
Foreign Large Cap
34%
29%
70%
81%
27%
Foreign Small/Mid Cap
62%
30%
75%
94%
34%
Diversified Emerging Markets
33%
16%
48%
44%
56%
Corporate Bond
37%
74%
61%
30%
46%
High Yield Bond
63%
28%
69%
55%
48%
Source: Natixis Portfolio Clarity®, Morningstar
Performance data shown represents past performance and is no guarantee of, and not necessarily indicative of, future results.


In any equity selloff, the goal is for the rest of the portfolio to provide some ballast to allow for liquidity and rebalancing opportunities. While Treasuries have proven to offset many past equity drawdowns, history tells us not to take this relationship for granted. Should longer duration strategies disappoint in the next equity drawdown, we believe cash, short duration government bonds, gold, and active management can each play a supporting role in a diversified portfolio.
CFA® and Chartered Financial Analyst® are registered trademarks owned by the CFA Institute.

1 Natixis Portfolio Clarity®, Factset

Investing involves risk, including risk of loss. Investment risks exist with equity, fixed income, international and emerging markets.

This material is provided for informational purposes only and should not be construed as investment advice. There can be no assurance that developments will transpire as forecasted. Actual results may vary. Index returns are not intended to imply any future performance of any investment product.

Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that from outside sources, to be correct, but cannot guarantee its accuracy.

Commodity-related investments, including derivatives, may be affected by a number of factors including commodity prices, world events, import controls, and economic conditions and therefore may involve substantial risk of loss.

Unlike passive investments, there are no indexes that an active investment attempts to track or replicate. Thus, the ability of an active investment to achieve its objectives will depend on the effectiveness of the investment manager.

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