The traditional view of investment diversification calls for a portfolio of 25 to 30 stocks from a wide variety of industries. Of course, stocks in a diversified basket will be more correlated to one another than to bonds, so textbooks tell us to further diversify by allocating a portion of our holdings to fixed-income investments. However, DailyAlts readers know that even this diversification is rarely adequate, which is why a portion of at least most portfolios should be allocated to alternative investments, defined as anything other than stocks, bonds, and cash.
In It’s All About Your Core, a new “Blue Paper” from Pioneer Investments, author Thomas Swaney makes the case for fixed income alternatives by providing historical evidence that the correlation between the performance of stocks and non-Treasury fixed income assets increases during bear markets. In other words, a diversified mix of fixed income securities may provide sufficient diversification during bull markets, but not during bear markets. Mr. Swaney, it should be noted, is Pioneer’s Head of Alternative Fixed Income for the U.S.
Higher Fixed Income Correlations During Crisis Environments
During the financial crisis from September 2007 to February 2009, alternative investments performed well relative to traditional asset classes, which lost ground across the board. Swaney looks at the worst of the period, from June 2008 to November 2008, and dubs it “The Great Recession.” He then shows that correlations between stocks and fixed-income investments, excluding Treasuries, increased dramatically during this period, as well in the following “highly stressed” markets: The Long-Term Capital Management crisis from May 1998 to August 1998; the “default cycle” bear market from April 2002 to September 2002; and even the post-Fukashima pull-back from May 2011 to September 2011.
In bull markets, by contrast, the performance of Treasuries is positively correlated with other fixed-income securities.
Since many fixed-income investments trade in tandem with stocks during bear markets, this leads Swaney to say these investments exhibit “equity-like risks.” The fact that investors don’t appreciate these risks leads them to misallocate resources, creating portfolios with higher risk levels than they’re aware of, and with insufficient reward potential for the actual risk being assumed. For this reason, Swaney says, “Investors may need a new and better core fixed-income portfolio that includes a different source of diversification to equity investments than what traditional techniques can offer” – in other words, investors may need alternatives.
Diversifying the Core Fixed Income Portfolio
Specifically, Swaney says fixed-income portfolios may benefit from exposure to strategies such as global macro, long/short, and fixed-income arbitrage. These strategies have historically had little correlation with broader market risk, and they all pursue positive absolute returns. Accessing strategies – via liquid alternatives – is likely to be more beneficial than simply adding more of the same securities in the name of diversification.
Of course, the elephant in any room full of fixed-income investors is the inevitable rise of interest rates in 2015 and beyond. Since bond prices and yields move inversely, rising rates will inevitably cause the value of existing fixed-income investments, with lower yields, to decline in price.
Conventional wisdom says this is a time when stocks should be doing well, which is the logic behind the old “60/40” portfolio split – but Swaney says that interest rates have been so low for so long that the typical relationship between rates and equities is unlikely to hold. In short, stocks could fall even as interest rates rise – in fact, most equity traders seem to think this will be the case, given the degree to which the Fed’s “quantitative easing” has aided the stock market’s rally.
If stocks enter a bear market even as interest rates are rising, this will keep with Swaney’s thesis that correlations between stocks and bonds increase during “highly stressed” markets. This scenario seems extremely plausible, if not inevitable, which is why Swaney encourages fixed-income investors to reexamine how their portfolios are constructed.
Instead of traditional long-only fixed-income exposure, Swaney says investors should add liquid alternatives with a strategy-based approach to gain exposure to strategies such as global macro, and that these holdings should be combined to create a better “core” fixed-income portfolio. This “more refined approach” to risk management should result in a portfolio that’s better able to withstand negative shocks, according to Swaney.