The bond diversification story is based on the strong negative correlation between stocks and bonds that has existed for over a decade, yet it is not a given that stocks and bond returns will move in opposite directions. A quick look at a very long history from a Wellington Management chart tells us that the negative correlation is the exception not the rule.
Along with any discussion of asset bubbles, there is a complementary discussion concerning tail risk. If there is a bubble, there is likely to be a tail in the future. Bubbles and tails are tied together, yet tail events can occur even if there is no bubble.
Strategic asset allocation as the name implies requires long-term return assumptions. There are often wide variations in the future forecasts. Many forecasts we have surveyed show positive expected returns, but the numbers are significantly lower than what investors have seen historically since the Financial Crisis. In general, Research Affiliates provides a good tool for analyzing the past and expected returns that we find helpful.
Diversification can come in many forms. One that is not often discussed is holding period diversification or the time- frame used for making a trading decision. Some strategies are successful based on the expected holding period of the investment and not just the trading process employed. For example, there could be two price-based systematic managers who use similar models, yet they will get very different returns based the calibration of the holding period, short-term versus long-term. In the case of trend-followers, there are some trends that last only a short-time and can only be captured through trading a short time-frame versus other trends that can last for weeks, months, or quarters. These are captured differently based on the look-back or speed of the models.
We believe that a volatility shock will generate a feedback loop that will force equity prices lower. High leverage tied to volatility targeted risk management will mean that any increase in volatility will lead to portfolio rebalancing and position cutting. This negatively correlated leverage effect between equity returns and change in the VIX is real, as measured by researchers at the New York Fed, see “The Low Volatility Puzzle: Are Investors Complacent?”.
Investors have shifted their focus to alternative risk premiums as a method for defining and allocating risk within a portfolio. The alternative risk premium framework can be employed in all asset classes but is especially useful in commodities given the large dispersion in markets and structural features that lend themselves to time varying risk premiums.
Investors should have a growing concern with the reach for yield in the current market. The reach for yield has pushed investors into illiquid issues where the risk profile has changed from credit/carry to credit/carry/illiqudity. Investors will generally receive a higher premium if an asset is illiquid. Unfortunately, illiquidity premiums are hard to measure; consequently, the traditional credit betas will not be properly measured and there could be the mistaken view that there is greater alpha from managers who hold these types of assets.
The latest performance numbers for Ivy League endowments have been nicely displayed in the chart below along with the 60/40 stock/bond portfolio. Since the development of the “endowment” model associated with Yale and the attention on Harvard, the largest endowment, there has been an unusual focus on these funds. There is a fair amount of dispersion between the best and worst managers in the group.
Implied volatility is usually higher than realized volatility so there is a positive volatility risk premium, except when there is a crisis or volatility spike at which time the volatility premium turns negative. A recent CBOE seminar presented a chart on the volatility premium to illustrate the risk.
Investors should be concerned about the unintended behavior from low volatility. Low volatility will lead to higher volatility in the future when investors become complacent about risk, the “Volatility Paradox”. This paradox has been discussed by Richard Bookstaber as early as 2011 and recently referred to in a post on his blog, Our low risk (low volatility) world.
Dan Fuss, the Loomis Sayles bond guru, has been working in fixed income for decades. He has developed a set of four “P’s” with central bank behavior for looking at the macro fixed income environment and his read is suggesting that caution should be applied to any forecast that believes bonds are safe.
And not only the pride of intellect, but the stupidity of intellect. And, above all, the dishonesty, yes, the dishonesty of intellect. Yes, indeed, the dishonesty and trickery of intellect.
-Leo Tolstoy
The spider chart is an alternative way of displaying data that may be useful at showing the strong diversification benefits versus different asset classes and alternatives. Correlations are looked at through a matrix form but the spider or radar graph may better display the most relevant information. Each node on the web may represent a different asset class and show the correlation of each to a single strategy.