The Envestnet Edge, September 2016

Diversification is working in 2016 (so far)

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Doomsayers notwithstanding, portfolios have performed remarkably well this year following 2015’s lackluster returns. This month, we examine how the past few years have affected investors’ expectations, how this year points to positive signs of a stabilizing economy and rising income growth to dispel fear and anxiety, and how that makes the case for diversification.

Recent volatility notwithstanding, what has been striking about 2016 as an investing year is how relatively good it has been. In fact, the return on a  diversified portfolio this year is competitive with many major asset classes, and has restored (for now) some confidence in the age-old mantra of diversification being among the most prudent of investing strategies. Many on Wall Street, however, seem to be viewing that strength as a sign of weakness. No one knows the future (though that doesn’t stop many from proclaiming they do), and crises are always possible. But the decent performance of assets this year should be a sign that markets are stable and performing decently, rather than a harbinger of bad times ahead.

Through the end of August, a basic diversified portfolio of 60% equities and 40% bonds returned nearly 7%, and that in a year widely characterized as volatile and uncertain. In truth, other than a bout of sharp up and down in January and early February, this year has been neither volatile nor uncertain. It has instead been steady and quietly strong. The last months may tell a different tale, but for now that’s where we are. Investors should take note: Esoteric strategies (such as those of many hedge funds, big bets, and lots of churning trades) garner attention but often fail in relation to simple diversification.

How did we get here?

Last year was challenging for investors in almost every area. Unless they magically lumped all their eggs in the basket of Facebook, Amazon, and Google stocks, investors faced flaccid returns. And because a very few (but highly publicized) names such as those internet stars did so well, the mediocre performance of the majority of investors felt even worse.

According to some studies that analyzed 2015 performance, nearly 70% of investors lost money for the year, even though the Nasdaq index in the U.S. was up and some bond prices performed decently as yields declined. To be fair, that followed a very decent 2014 for passive and index funds especially (active managers on the whole have struggled for the past three years against their relative indices).

With investor psychology still fragile even seven years removed from the 2008-2009 financial crisis, last year’s returns for supposedly conservative asset allocations models were construed as a sign of impaired markets. If even a tried-and-true investing strategy of diversification failed, and hedge funds run by supposedly the smartest investors had returns that were equally dismal, then surely that was a portent of bad things to come.

In reality, 2015 was a mediocre year, not a disastrous one. Compared to truly bad years, such as 2008, when many lost 20%, 30% or even 40% or more (the supposed stability of diversification notwithstanding), 2015 was actually just fine. It was a poor year, but not a 100-year flood that left devastation in its wake (unless one were heavily invested in oil and commodities, in which case it was indeed, to quote the Queen, an annus horribilis).

That brings us to 2016. Through the end of August, almost every major asset class is in positive territory, including not just U.S. equities and bonds, but specific fixed income (including high-yield and emerging markets debt), real estate funds, commodities, and specialty sectors. The exception is hedge funds’ poor performance, which according to the Barclays Hedge Fund index, is up over 3% year-to-date but significantly lags that of a 60%-40% diversified, plain-vanilla portfolio that is up between 6% and 7%.

Of course, depending on the blend of that diversified portfolio, investors are seeing either better or worse returns—better if more aggressive and riskier (with weightings in high-yield and emerging markets debt), worse if they were concentrated in foreign developed markets equities. To be fair, those fixed income categories (along with commodities) did very badly in 2015, down double digits, and in the case of commodities, well into the negative double digits. Investors with multi-year exposure to those asset classes are likely still down (or at best flat) from their cost basis, so although the absolute returns since January look gaudy, they only look so because of several truly ugly years.

Why, given how the year has shaped up so far, is the mood so cautious and occasionally gloomy? Why the “sell everything” mantra from noted investors, such as bond manager Jeffrey Gundlach over the summer, or the sour notes recently sounded by Wall Street luminaries at the Delivering Alpha conference in New York, where voices of Carl Icahn, Ray Dalio of Bridgewater, and Elliott Management hedge fund manager Paul Singer spoke of “very dangerous” bond and stock markets?

Some of these concerns are evergreen. Many professional managers continue to see the years of low interest rates and the accommodative policy of the Fed and other central banks as a market distortion that has elevated asset prices and sown the seeds of a violent correction or contraction down the line. They are also skeptical of real world economic conditions and of what admittedly has been a period of poor revenue growth for many major companies.

A few things bear mentioning: In most of the world major economies, economic fundamentals are improving, albeit slowly and not impressively. Income growth is finally in evidence in the United States, with the median group showing more than 5% gains in 2015, according to the just-released U.S. Census Bureau report. Revenue growth has returned to many sectors, and inflation remains low, so much so that the Fed is still having a hard time justifying further rate increases.

It may be that the smart minds mentioned above are right about looming dangers. If so, then those diversified portfolios that are doing so well this year will lose money—but unless we are facing a global financial meltdown, they will not lose as much as those concentrated in one sector or another. And if we do face such a meltdown—always possible but hardly probable—the only safety will be not to be invested in financial markets at all, and to have a good supply of canned food in the pantry.

In the meantime, investors should recognize that this year has been better than the swirl of anxiety suggests. It’s an election year unlike most in memory, and the nature of today’s economy remains difficult to understand. Change seems to be on the verge of accelerating out of control, hence the anxiety. But the reality is more stable, and for now, the strategy of diversification has been vindicated.

Advisor Takeaway:

Basic diversified portfolios have returned around 7% through the end of August, yet many decry that steady, respectable performance with portents of gloom on the investment horizon. Although investor psychology is still fragile in the wake of the devastating financial crisis and last year’s mediocre performance, the sour notes being sounded by Wall Street luminaries are not warranted, given the stability of improving economic fundamentals, income and revenue growth, and low inflation. Decent performance for major asset classes thus far should restore investor confidence and vindicate diversification as a prudent investment strategy.