July 10, 2017
Written by Nathan Erickson, CFA®, CAIA, Chief Investment Officer
If you have gone to an Arizona Diamondbacks game at Chase Field over the last few years, you may have seen an in-game promotion called “Will it Float?”. The promotion is sponsored by Fry’s Food Stores and involves a fan contestant guessing whether an item thrown into the swimming pool behind center field will float or sink. If the contestant guesses right, they win a gift card from Fry’s Food Stores.
The game is surprisingly more challenging than it looks. For example, a can of regular Coke will sink, while a can of Diet Coke will float. By applying scientific principles, one can determine if an object will float or sink in water, based on its density or the volume of water it displaces. Without science, however, logic may not lead us to the correct outcomes. As another example, an orange with the peel will float; an orange without the peel will not. An uneducated guess is really just a guess.
There is a similar lesson to learn when it comes to constructing a well-diversified investment portfolio. The term diversification may be one of the most overused in all of finance, but is a critical factor to investing. The key to successful diversification is owning investments or asset classes that are truly unrelated. A frequent error that investors make is owning several investments and thinking they are diversified when really, they are not. The true test of diversification is correlation, which measures the relationship between one investment’s return and another. The closer the correlation is to 1, the more related two investments are to each other.
For example, consider the relationship between U.S. large company stocks (represented by the S&P 500 index), U.S. small company stocks (represented by the Russell 2000 index), and U.S. bonds (represented by the Barclays Aggregate Bond Index):
U.S. large and small company stocks are highly correlated at 0.90. A loose interpretation of this number would be that nine out of ten times when large company stocks go up, small company stocks go up. An investor who owns large and small company stocks may think they are well diversified but, in reality, all of the investments in their portfolio are going to move in the same direction, good or bad.
Bonds, on the other hand, have virtually no correlation with large company stocks or small company stocks. This means that the direction of bonds cannot be determined by the direction of stocks because they are not related. This does not mean they won’t both move in the same direction sometimes, but if they do it is purely coincidence.
Advancing Beyond Simplicity
The diversification benefit of bonds is a well-known fact that spans decades of investment history. However, the last several decades have seen the introduction of more advanced diversification options like real estate, private equity, and hedge funds. The objective of adding these investments remains consistent: a portfolio invested in several things that have little to no relationship with one another should have lower risk and more consistent returns than a portfolio invested in several things that are highly related to one another. While intuitively one might think that public equities have little relationship with real estate, private equity, and hedge funds, in reality, that may not be the case.
If we look at index data over the last 15 years, we can see that there is a fairly strong relationship between U.S. large company stocks and several traditional alternative options. For example, private equity has a 0.76 correlation with equities, hedge funds a 0.75 correlation, and publicly-traded real estate investment trusts (REITs) a 0.69 correlation.
This does not mean that there is no benefit from these investments. They are different sources of return and can complement a portfolio of stocks and bonds. However, they may not diversify the way an investor really wants them too, which is typically when stock markets are down. In other words, an investor may think it floats, but it may actually sink.
If we look particularly at the 2008 financial crisis, we can see that these alternative investments provided some benefit, but they all lost money during the downturn to some extent.
When U.S. large company stocks had a drawdown of nearly 50% in 2008, publicly traded REITs were down nearly 70%, private equity was down 25%, and hedge funds were down 20%. While they weren’t down as much, these alternative investments all contributed to negative returns in a portfolio. They offered some diversification, but correlations of 0.7-0.8 mean there is at least a loose relationship with equity markets. Intuitively, this makes sense. When we went through a recession and the second worst market crisis in history, it had an impact on any asset related to business, including real estate.
While these investments lost money during this period, one can see from looking at the chart that, aside from publicly traded REITs, they all recovered at a faster pace than U.S. large company stocks as well, taking from one-fourth to one-half the amount of time to return to previous levels. These aren’t bad investments, but if you could improve upon that and get better diversification in a portfolio, wouldn’t you want to?
From Advanced to Innovative
As one can imagine, the list of objects that can be thrown into a pool to test whether they float or sink is limitless. While the investment universe isn’t quite as broad, it does extend far beyond conventional asset classes of stocks, bonds, real estate, and commodities. At MRA Associates, we believe there is value in throwing as many objects as we can into the pool to find out if they truly add value. We review hundreds of investment ideas every year generated from many different sources. For those that meet our initial test of logic and viability, we evaluate the benefit they may add to an overall portfolio. If a portfolio can be improved, then the investment warrants serious due diligence on our part to ensure the academic persistence and the quality of the organization executing the idea.
This process has driven our investments in reinsurance, farmland, life settlements, and other investments over the last several years. We know these asset classes and investments may appear unconventional to some, but their diversification benefits are meaningful. For example, compare the correlations of these investments over a similar time period (limited by the inception of the SwissRe Global Cat Bond Index):
With correlations to stocks of 0.13 for farmland, 0.26 for reinsurance, and 0.02 for life settlements, these investments have almost no relationship with the traditional stock market. While our life settlement investment has only been around since 2010 we can see that, over the past 15 years where there were several stock market drawdowns, these investments had very little participation:
We want to ensure that readers do not draw the wrong conclusion from this information. We are not saying these investments cannot lose money or do not have risk. They would not pay an investment return if there was no risk associated with them. However, this data shows that over the last 15 years they have had almost no relationship with the risk of the U.S. stock market. Intuitively this makes sense. Farmland profits are based on supply and demand of row crops such as corn and soybeans, which have no direct relationship with equity markets and historically have remained relatively stable in most economic environments. Reinsurance earns a return by providing insurance coverage against weather events and other low-frequency occurrences, which are again unrelated to equity markets. Life settlements earn a return based on the actuarial analysis of life insurance policies, again unrelated to equity markets. There may be a point in time when one or all of these investments lose money at the same time as the stock market. However, they are unlikely to lose money because of the stock market.
Returning to diversification, any diversification is better than no diversification. Someone with one stock should attempt to own ten. Someone with just stocks should consider owning bonds. Similarly, someone with just stocks and bonds should consider owning other assets. Diversifying into other asset classes will almost always add value. However, we believe a willingness to evaluate the landscape of investment options can lead to much better outcomes, particularly when it matters most. While these investments may be unfamiliar or sound unusual, we have thrown them in the pool and they float. When it comes to protecting and growing our clients’ wealth, we believe all options should be considered, and the best solutions should be utilized.
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US large company stocks are represented by the S&P 500 Total Return Index. US small company stocks are represented by the Russell 2000 Total Return Index. US bonds are represented by the Barclays US Aggregate Bond Index. Private Equity is represented by the Cambridge Associates US Private Equity Index. Hedge funds are represented by the Credit Suisse Hedge Fund Index. Publicly traded Real Estate Investment Trusts (REITs) are represented by the Dow Jones US Select REIT Total Return Index. Farmland is represented by the National Council of Real Estate Investment Fiduciaries (NCREIF) Rowcrop Farmland Index. Reinsurance is represented by the SwissRe Global Cat Bond Total Return Index. Life Settlements are represented by the Vida Longevity Fund, L.P. Correlation and performance data are quarterly annualized returns. Data provided by Morningstar direct, through the most recent available date, which in some cases is 12/30/2016.