Diversification

Is Diversification Working?

Diversification Scorecard: Q2 2020
July 14, 2020

After record volatility and the quickest-ever decline into bear market territory during the first quarter, global equity markets roared back in the second quarter, with a record-setting recovery rally fueled by a massive stimulus package, supportive monetary policy, flattening of the infections curve, and an optimistic outlook for the economy’s reopening. The quarter was a tale of two markets, however, with strong returns and declining volatility in April and May, followed by a flatter path and somewhat higher volatility in June as a result of concerns about the magnitude of the market rebound and increasing coronavirus infections and hospitalizations in several US states. The sharp moves in equity prices and option-adjusted spreads, V-shaped for the former and reverse V-shaped for the latter, indicate that investors expect a quick bounce back in economic activity. Only time will tell whether that assumption is realistic.

Within equities, domestic stocks led the way, posting strong absolute returns, followed by emerging markets equities that outpaced international developed markets. In a reversal from previous quarters, small cap outpaced large cap, and growth equities largely outpaced value across all capitalizations, further increasing the return differential between the two factors. The difference in the year-to-date returns between the Russell 3000 Growth and Russell 3000 Value indices is currently 25.73%. The first-half 2020 underperformance is quite striking, in that value equities historically have tended to prove more buoyant in market downturns. The buoyancy of growth strategies has been led by tech and communications stocks, whereas value strategies have been weighed down by their exposure to energy stocks.

Fixed income asset classes realized more muted returns. The yield on the 10-Year U.S. Treasury Note stayed in a relatively tight range, closing the quarter at 0.66%, four basis points lower from the end of the first quarter. Spreads tightened during the quarter on both investment grade and high yield debt thanks to the continued support from the Federal Reserve’s corporate bond purchasing program. High yield bonds, which are highly correlated with equities, posted the strongest returns within fixed income. Investment grade bonds followed closely, with a return of 8.98% for the Barclays US Corporate Index, whereas the Barclays US Aggregate Bond Index ended the quarter up 2.90%. Commodities also posted positive returns for the quarter, as the price of oil rebounded and gold prices continued their march higher.

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

Diversification Scorecard: Q1 2020
April 14, 2020

Global markets suffered in Q1 as the coronavirus outbreak worsened. The impact of the pandemic on the global economy continued to grow, wreaking havoc across financial markets. This was only exacerbated by the oil price war that was initiated after OPEC members failed to agree on production cuts. Equity markets tumbled, with most of the major indices posting negative, double-digit returns in the first quarter. The S&P 500 Index lost 19.60% in Q1, closing out both its worst quarter since 2008 and its worst first quarter in history (breaking the previous record set in 1938). In response to this unprecedented crisis, the Federal Reserve cut interest rates to near zero and launched a massive, $700 billion QE program. A historic $2 trillion stimulus package also was passed by Congress in late March (the largest emergency aid package in US history), in an effort to soften the pandemic’s blow to the American economy as we witnessed its longest expansion on record come to an end.

The US economy’s growth remained steady in the fourth quarter of 2019, as the Bureau of Economic Analysis reported its third estimate of Q4 GDP at 2.1%, in line with third-quarter growth and the prior estimate. However, the economic effects of the outbreak have begun to appear in the data, with some economists forecasting as high as a 30% contraction (annualized) in US growth in the second quarter of 2020. The adverse impact of COVID-19 on employment also has started to appear in the data. Unemployment had continued to surprise all the way through February, with the unemployment rate hitting a 50-year low at 3.5%, as employers added 273,000 jobs during the month, above the consensus expectations of 175,000. Unfortunately, we have already started to see a reversal in those numbers, with the unemployment rate rising to 4.4% in March and 701,000 jobs lost. Weekly jobless claims hit a record high of 6.6 million for the week ending April 4, bringing the total number to nearly 17 million since the pandemic shut down the American economy.

In a risk-off environment, demand for US Treasurys was high, as investors sought a safe haven when equity markets began to decline. Lower-quality debt sold off, with panicked investors bidding up Treasurys, sending their yields close to historical lows. The U.S. Treasury yield curve steepened over the quarter, with yields on the shortest-term maturities declining relative to the intermediate- and long-term portions of the curve. The yield on the benchmark 10-year US Treasury Note declined, ending the quarter at 0.67%, compared with 1.92% on December 31.

Diversification produced mixed, though mostly negative, results over the quarter. Equity markets experienced a steep sell-off, underperforming fixed income securities by a wide margin. Diversification from exposure to international developed and emerging markets equities detracted from relative returns, as both asset classes trailed domestic equities in Q1, with the Russell 3000 Index down 20.90% vs. -22.83% for the MSCI EAFE and -23.60% for the MSCI EM indices. Large cap and growth exposures were the biggest equity contributors from a high level. Diversification through small and mid cap equities detracted from returns over the quarter, as the Russell 2000 Index declined 30.61% and the Russell Mid Cap Index lost 27.07% compared with -20.22% for the Russell 1000 Index. Value lagged growth for the quarter, detracting from relative performance, with growth outperforming across large, mid, and small cap equities. Exposure to REITs and commodities generally detracted from relative performance, as they could not keep pace with large cap domestic equity. Although fixed income securities posted mixed returns, exposure, by and large, contributed to performance, as many investors flocked to the safety of Treasurys. Diversification across fixed income was generally subtractive over the quarter, as high yield bonds, international bonds, emerging market bonds, and bank loans all underperformed core bonds.

Though diversification seemingly can be viewed as detrimental over the quarter, it is important to consider it within a longer-term context as well. Many of the benefits that are not observed as easily over a quarter are much more apparent over a longer time period. It would behoove investors to remember that many of the asset classes that suffered the worst during the 2008 Global Financial Crisis bounced back the best afterward. We saw a huge decline in emerging market equities in 2008, for example, closing out the year down 53.33%, only to see that same asset class end 2009 up 78.51%. International and mid cap equities had similar stories. Within fixed income, high yield, bank loans, and emerging market bonds all followed a similar suit, posting some of the largest declines in 2008 only to post some of the best returns in 2009. It is important in times like these, in the midst of sharp market declines, for investors to remain focused on their long-term financial plan and not let short-term volatility deter them from the benefits of diversification.

Contributors (+):

• Fixed income exposure contributed to performance, as many investors flocked to the safety of Treasurys.
• Domestic equity outpaced international, and developed equity markets outperformed emerging markets.
• Growth outperformed value across all market capitalizations.
• Large cap outperformed both mid and small cap stocks.
• Investment grade bonds outpaced high yield, and domestic fixed income outpaced international.
• Information Technology, Health Care, and Consumer Staples were the strongest-performing S&P 500 Index sectors on a relative basis.

Detractors (-):

• Equity exposure detracted from performance, as equity markets experienced a sharp sell-off, underperforming fixed income securities.
• Emerging markets and international stocks mostly trailed domestic stocks.
• Value lagged growth across all market capitalizations.
• Small cap stocks were hit especially hard, followed by mid cap, as both trailed large cap.
• REITs and commodities mostly trailed equities for the quarter.
• The Energy, Financials, and Industrials sectors were the poorest relative performers.
• High yield, international bonds, emerging markets bonds, and bank loans underperformed core bonds.

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

Diversification Scorecard: Q4 2019
January 9, 2020

As markets wrapped up the second decade of the 2000s, equities surged higher to finish 2019. Market participants continued to look past any underlying threats to the sustained growth that has pushed stock indices to record highs, disregarding trade conflict between the US and China, slowing global growth, and various geopolitical concerns. Positive developments were given a higher priority among investors, who rallied behind the longest US economic expansion in postwar history, and an aging bull market not yet ready to quit. Central bank accommodation returned in 2019 as a key driver for stock appreciation, with the Federal Reserve cutting rates three times for a total reduction of 75 basis points.

For the full year, large cap domestic stocks led, with the S&P 500 gaining 31.5%, outpacing international equities, which returned 22.7% for the MSCI EAFE, and small cap equities, which experienced a 25.5% gain on the Russell 2000 Index. Growth stocks continued their dominance over value stocks, with higher returns for growth-oriented stocks across all market caps. Emerging markets equities trailed developed stocks, with the MSCI Emerging Markets Index gaining 18.9% for the year. However, its strong gain of 11.9% in Q4 led all major indices for the quarter. Within fixed income, the Barclays US Aggregate Bond Index posted a solid return of 8.7% behind lower interest rates. High yield bonds added value, while global bonds and shorter-duration debt trailed.

Diversification offered little benefit in 2019, as a portfolio invested 60% in the S&P 500 Index and 40% in the Barclays US Aggregate Bond Index would have returned 22.4%, outpacing a fully diversified portfolio allocation. This type of diversification failure is one that has proven common over the past decade, as US stock markets operated under conditions that included ultra-low interest rates, widespread central bank accommodation, strong consumer spending, and a more robust domestic economy than Europe or Asia. Although the US-centric stock rally of the past decade has done little to showcase the principles of diversification, analyzing the 2000-2009 period may provide a closer perspective of what the next ten years may have in store.

Over the ten-year period of 2000-2009, diversification across multiple asset classes and investment styles was highly in favor. Domestic equities mostly trailed international by 250 basis points annually, with a return of -1.0% for the S&P 500 Index versus an annualized return of 1.6% for MSCI EAFE. Emerging markets equities had a strong decade, posting a 10.1% annualized return. Small cap stocks outpaced large cap, with a 3.5% annualized return for the Russell 2000 Index. Value stocks widely outpaced growth stocks, with an annualized difference of 646 basis points within the Russell 1000 Index. REITs gained an annualized return of 10.7%, and commodities (one of the worst performers from 2010-2019) performed well in the 2000s, with an annualized return of 7.1%. Within fixed income, high yield, Treasury Inflation-Protected Securities (TIPS), emerging markets debt, and global bonds added value, even with a strong decade for the Barclays Aggregate Bond Index, which returned 6.3% annually.

The 2000s decade is widely remembered for the major events that drove performance, including the tech bubble and its bursting, September 11, the rise of the housing bubble, the global financial crisis, and the start of the subsequent market recovery. Among these events, diversified investors benefited, as exposure to international, small and mid-cap stocks, value stocks, emerging markets, commodities, and diversified fixed income added value, while the S&P 500 Index and growth stocks in general provided negative returns.

The juxtaposition of the 2000s and the 2010s help to showcase the widespread performance difference that investors experienced while practicing diversification. Will we return to the asset allocator’s utopia of the 2000s, or will the performance profile of the 2010s linger, with US large cap dominance, growth at any price, and diversification continuously taking a back seat? Only time will tell, but taking a balanced approach to diversification continues to be our favored and most prudent position, as it provides the benefit of lowering overall portfolio risk, and as we have seen from the 2000s results, does not have to come bearing the expense of worse returns.

Contributors (+):

• Growth outperformed value, with 985 basis points difference within the Russell 1000 Index. Technology was the top-performing sector, while energy was the worst-performing sector.
• High yield bonds outpaced core fixed income.
• Domestic equities outperformed international stocks.

Detractors (-):

• Emerging markets equities trailed developed markets stocks.
• Global bonds trailed domestic fixed income; however, emerging markets debt outperformed.
• Small cap stocks trailed large cap, with the S&P 500 Index returning 31.5% compared with 25.5% for the Russell 2000 Index. Mid cap stocks performed better but finished slightly behind large cap.
• Commodities widely trailed global equities and finished slightly behind core fixed income.

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, Russell 2000 TR USD  MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, BBgBarc US Agg Bond TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

Diversification Scorecard: Q3 2019
October 21, 2019

The global economy showed some signs of exhaustion over the third quarter, no doubt negatively affected by the ever-escalating trade war between the US and China, which resulted in higher tariffs placed on each other’s imported goods. China’s economic growth over the third quarter was the slowest year to date, as manufacturing and the services sectors both worsened. Within the US, indicators of business confidence are at the lowest levels since 2012; however, consumer sentiment and the labor market remain strong. In an effort to support the economic expansion, the Federal Reserve (the Fed) reduced the benchmark interest rate by 25 basis points, the second cut this year, keeping it within a range of 1.75% to 2.00%. Additionally, the overnight repurchase market expanded in the last few weeks of the quarter, as the Fed intervened in an effort to keep the overnight rate under control.

Markets ended the quarter with mostly positive returns, with domestic fixed income securities, represented by the Barclays US Aggregate Bond Index, returning 2.27%, and US equity, represented by the Russell 3000 Index, returning 1.16%. International equity, represented by the MSCI ACWI Ex USA index, sold off, declining 1.80%. Much of the growing concern about the likelihood of a coming recession fueled a flight to quality that benefited fixed income securities, driving the yield on the 10-Year Treasury Note to levels not seen since early 2016. Additionally, gold and silver sharply appreciated to multiyear highs. The flight to quality also affected the domestic equity markets, as small cap stocks sold off, underperforming large cap by a wide margin.

Diversification offered little benefit over the third quarter, as a portfolio invested 60% in the S&P 500 Index and 40% in the Barclays US Aggregate Bond Index outperformed more diversified portfolios that included other asset classes such as mid and small cap stocks, international equity, lower-quality debt, and commodities. However, given the major risks of the current macro environment, it is even more important to follow a diversified investment approach to help minimize the portfolio’s drawdowns during volatile periods.

As a point of interest, a break in the trend of growth over value occurred in Q3 and marked only the third quarter in the past three years in which the Russell 3000 Value Index outperformed the Russell 3000 Growth index. Moreover, in looking at the trailing 12 months, value stocks have pulled ahead of growth by almost 0.50%. This change in trend further highlights the necessity of building a diversified investment portfolio, as asset classes’ relative performance will change with time and, in some instances, in dramatic ways.

Contributors (+):

• Value outperformed growth, possibly marking a long-term trend reversal.
• Real estate posted strong returns in the third quarter, widely outperforming the broader equity market. Utilities also posted strong results, rising 9.30% in Q3.
• Domestic equities outperformed international stocks, with large cap leading the way.

Detractors (-):

• Emerging markets equities trailed developed markets stocks, with weakness driven by MSC China, which declined 4.80%.
• Commodities lost ground in the quarter despite strong price appreciation from the precious metals sector.
• Bank loans trailed traditional bonds.
• Small cap stocks sold off, trailing large cap stocks.

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

Diversification Scorecard: Q2 2019
July 12, 2019

The end of June concluded another quarter of positive returns for equities, albeit not as impressive as the returns posted during the first quarter. After rising by more than 4% in April, equities were hammered in May, with the S&P 500 Index dropping more than 6% as tariffs and trade wars between US and China rattled investors’ nerves. In June, Federal Reserve (the Fed) Chair Jerome Powell’s remarks that the FOMC “will act as appropriate to sustain the expansion” helped spur a steep rally in stocks, as the S&P 500 Index gained more than 7% to end the quarter up 4.30%. The MSCI EAFE Index followed with a 3.68% gain, while emerging markets equities trailed developed markets, posting a meager return of 0.61% for the quarter. Gains were not limited to equities, as Treasurys caught a panic-type bid, with the 10-year yield dropping to 2.00%, down nearly 41 basis points for the quarter and 12 basis points below the three-month Treasury Bill yield. The Fed left interest rates unchanged after its June policy-setting meeting. Global bonds trailed domestic fixed income for the first two months of the quarter, but reversed the early disadvantage during June to end the quarter ahead of domestic bonds. The Barclays Global Aggregate ex US posted a 3.42% gain compared with a 3.08% return for the Barclays US Aggregate Bond Index. Lower-quality debt generally trailed, with the Barclays US Corporate High Yield Index rising 2.05%. The more aggressive portfolios, with higher allocations to equities, outperformed the more conservative ones.

Growth continued to outpace value in the US and international markets, and large cap outperformed small and mid cap equities. Commodities ended the quarter in red, with the Bloomberg Commodity Index down 1.19%, negatively affected by the Energy sector, which was pounded during the quarter. Given the strong returns posted by US large cap equities, a portfolio invested 60% in the S&P 500 Index and 40% in the Barclays US Aggregate Bond Index outperformed more diversified portfolios that included other asset classes such as mid and small cap stocks, international equities, lower-quality debt, and commodities. Defending diversification’s role has been difficult in the past few years’ markets, in which high beta, high growth, and high valuation stocks were bid up substantially, thanks to the prevailing risk-on environment. We are in fact experiencing the longest bull market in history, with growth equities far outpacing value and small cap stocks trailing large cap.

However, diversification’s role as a volatility dampener should be judged over full market cycles. Different asset classes’ prices are influenced by various economic factors and unique supply/demand dynamics. For example, commodities tend to perform well in late cycles and early recessions, as inflationary pressures increase and interest rates fall to stimulate economic activity. Within fixed income, segments that are most sensitive to economic conditions such as high yield, senior loans, and emerging markets debt perform well during the early phases of a cycle, which are characterized by increased economic activity and improved corporate earnings and credit conditions. When the economy slows, consumers buy less, corporate profits fall, and stock prices decline, so investors prefer the regular interest payments guaranteed by high grade bonds. During the last 10 years, we experienced strong bull markets marked by solid corporate profits and risk taking, making equities the clear winners. However, during economic slowdowns and contractions accompanied by market drawdowns and increased volatility, diversifying with different asset classes can help smooth out the volatility of the stock market and offer the best risk-adjusted performance for risk-averse investors.

Contributors (+):

• Equity exposure was once again a contributor to performance as equities cruised higher.
• Domestic equities outperformed international stocks.
• Growth outperformed value across all market capitalizations.
• Large cap led the way, followed by mid cap and small cap stocks.
• Investment grade outperformed high yield debt.
• Global bonds and emerging markets debt outperformed domestic fixed income.

Detractors (-):

• Emerging markets equities trailed developed markets stocks.
• Value continued to lag growth across all market capitalizations.
• Commodities lost ground in the quarter as a result of weakness in the Energy sector, which plummeted in the second quarter.
• Real estate lagged equites after it posted strong results in the first quarter.
• Bank loans trailed traditional bonds.

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

Diversification Scorecard: Q1 2019
April 15, 2019

Markets rallied across the board in the first quarter of 2019, rebounding from the sharp sell-off experienced in Q4, with most indices recouping losses seen in the fourth quarter. Many of the fears that contributed to the sharp downturn at the end of last year subsided in Q1, as the Federal Reserve (the Fed) took a more dovish stance on rate hikes, the record-long US government shutdown finally came to an end, prospects for a US/China trade deal improved, and concerns surrounding a near-term US recession eased. 

The S&P 500 Index’s loss of 13.52% in Q4 was followed by a gain of 13.65% in Q1, its best quarter since 2009, marking the tenth anniversary of the bull market that began in March 2009. The US economy grew at a pace of 2.20% (revised down from 2.60%) in Q42018, lower than the previous quarter’s growth rate of 3.50%. Though US economic growth is showing signs of slowing, with corporate earnings on the decline, data still shows sound fundamentals and steady growth, especially when compared with other developed markets. Unemployment remains at historical lows of 3.80%, and wage growth has been steady. The yield on the 10-Year U.S. Treasury Note continued to decline in Q1 and fell below the 3-month yield as we witnessed the yield curve invert in March. Though it has since reverted, fears that a recession is on the horizon still loom, as the past seven recessions have been preceded by yield curve inversions.

Diversification produced a somewhat mixed bag for the quarter. Though equity exposure in general contributed to performance, diversification from exposure to international developed and emerging markets equities detracted from relative returns, as both asset classes trailed domestic equities in Q1, with the Russell 3000 Index up 14.04% vs. 9.98% for the MSCI EAFE and 9.91% for the MSCI EM indices. Diversification through mid and small cap exposure, however, added value over the quarter, as both outperformed large cap, with mid cap leading the charge. Investors also benefited from exposure to REITs, as the asset class outpaced many equity asset classes, returning 15.72%. Value lagged growth for the quarter, detracting from relative performance, with growth outperforming across large, mid, and small cap equities. Diversification via commodities also detracted from a relative perspective, as they could not keep pace with large cap domestic equity, returning only 6.32%.

Though fixed income provided positive returns for the quarter, results were typically more modest than equities. Diversification across fixed income was generally additive to relative performance as high yield, emerging markets bonds, and bank loans outperformed core bonds. International bonds slightly trailed core bonds, but were not a significant detractor on a relative basis.

Contributors (+):

• Equity exposure contributed to performance, as stocks rebounded from fourth-quarter losses across most asset classes.
• Growth outperformed value across all market capitalizations. 
• Mid cap outperformed both large and small cap stocks.
• Real estate, once again, outpaced most equities for the quarter.
• High yield, emerging markets bonds, and bank loans outperformed core bonds.

Detractors (-):

• Emerging markets and international stocks mostly trailed domestic stocks.
• Value lagged growth across all market capitalizations.
• Commodities gained for the quarter but underperformed most equity asset classes, detracting on a relative basis. 
• Fixed income provided positive returns, but results were typically more modest than equities.
• International bonds slightly trailed core bonds

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

Risk assets closed out the fourth quarter in free fall, as stocks posted both the worst December since the Great Depression (1931) and the worst Q4 since 2008. Domestic equities wiped out the double-digit gain that they held at the end of September, and international equities added to their losses. Concerns that the Federal Reserve will continue further down its path of hiking rates, an ongoing trade war with China, an aging bull market, and geopolitical instability were among the major issues that led to widespread selling. The S&P 500 lost 13.5% in Q4 and finished the year with a loss of 4.4%, its first calendar year total return loss since 2008. With the exception of the S&P 500, all major indices fell more than 20% from their peak, entering into bear market territory (characterized as a 20% decline). The S&P 500 escaped by the skin of its teeth, plunging only 19.8% from its September 20th high to the low reached on Christmas Eve.

Aside from all the worry that crept into the market in Q4, the underlying data continued to be mostly positive. The US economy grew at a 3.4% pace in Q3, following 4.2% growth in Q2. Employment data continues to be quite strong, with an unemployment rate under 4%, and the change in monthly nonfarm payroll additions averaging 254,000 in the fourth quarter. The ISM Manufacturing Index remains positive at 54.1. Despite these optimistic readings, the lack of certainty regarding interest rates, trade with China, and geopolitical anxieties tipped the scale in favor of a plunge.

Amid the sell-off at year-end, let’s examine how diversification held up. Equities certainly were hit the hardest in a classic risk-off quarter, with many of the names that have performed so well, including the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google), bearing the brunt of the pain, as these five stocks plummeted on average by -23.4%. Growth trailed value for the first time in the past eight quarters, as large cap value delivered a -11.8% return compared with -15.9% for large cap growth. This theme extended to small cap, which was met with even deeper selling pressure, as small cap growth lost 21.7%. Although investors had few places to hide in the equity sell-off, they benefited from their international and emerging markets exposure. The MSCI EAFE Index’s return of -12.5% outpaced the -13.5% return for the S&P 500 Index by 100 basis points, but emerging markets exposure provided even better relative performance, surpassing the S&P 500 Index by 605 basis for a loss of 7.5%. Commodities and REITs also escaped much of the impact, posting smaller losses. Although most equity asset classes suffered from widespread selling pressure, diversification did add some benefits from exposure to international, emerging markets, commodities, REITs, and the positioning of value over growth.

Fixed income, which naturally has not generated as much attention relative to equities over the ten-year bull market in stocks, provided considerable protection and downside support for investors in both Q4 and 2018. Although we often look at diversification separately within equities or fixed income, it is important to remember that combining both equities and bonds is vital in a balanced and diversified portfolio. Fixed income serves as diversifier and ballast to offset the volatility and risk of stock allocations in a portfolio. As investors rushed to sell equities in Q4, many piled into bonds, leading to a 1.7% return for intermediate bonds, and pushing their full-year return into slightly positive territory. Further diversification across fixed income did not add relative value, as high yield, bank loan, and even international fixed income provided lower returns than core bond exposure. However, these assets still held up significantly better than equities. Despite the poor grade for fixed income diversification, bonds’ victory over stocks in Q4 served as a big win overall for portfolio diversification.

As 2018 came to a close, diversification proved its worth for investors. Fixed income exposure helped to lessen portfolio losses from widespread equity selling. Value equities offset growth and small cap losses. Emerging market, REITs, and commodities contributed to relative results. We once again were reminded of the importance of diversification and the role that multiple asset classes can play in lessening overall portfolio risk and increasing the potential for stronger long-term results.

Contributors (+):

• Fixed income exposure, mostly higher quality debt benefited, as investors flocked to bonds for safety
• Value stocks outpaced growth stocks and were relative contributors to overall performance
• Emerging markets and international stocks mostly outperformed domestic
• Real estate and commodities exposure outpaced most equities for the quarter
• Utilities was the only positive sector in the S&P 500 for the quarter, gaining 1.4%

Detractors (-):

• Equity exposure impaired performance as stocks faced widespread selling pressure
• Small cap stocks were hit especially hard, followed by mid cap, as both trailed large cap
• Growth lagged value by more than 400 basis points within the Russell 1000 Index
• High yield and bank loan trailed core bond, as higher-quality debt outperformed

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

Domestic equity markets rallied, posting the best quarterly results so far this year, fueled by robust corporate profits and encouraging economic data. Although tariffs and trade war rhetoric continued to dominate the news, trade war fears subsided somewhat toward the end of the quarter after trade deals were signed with Mexico and Canada. Trade negotiations with China came to a halt instead, with the current administration escalating the stand-off and China announcing retaliation. US real gross domestic product grew by 4.2% in the second quarter. As expected, the Federal Open Market Committee announced another 25 bps rate hike in September, bringing the target interest rate to a range of 2.00%-2.25%. While the US engine continued to operate at full speed, others did not. In Europe, the soft patch registered in the first half of the year persisted in the third quarter, while emerging market stocks and currencies remained under pressure. Over the quarter, diversification did not add value as a diversified portfolio trailed a passive large-cap approach, such as holding the S&P 500 Index. More specifically, domestic large cap equity outperformed all other asset classes, with commodities and emerging market equities struggling the most. Fixed income finished the quarter almost flat. Within fixed income diversification helped as high yield corporate bonds, emerging market debt, and bank loans outperformed the Barclays U.S. Aggregate Bond Index.

Moving into the fourth quarter, it may be worthwhile to review previous fourth quarters to get a better sense of the value of diversification. The fourth quarter of 2017 was a particularly strong quarter with positive returns from almost all asset classes. Furthermore diversification added value as international equity posted strong relative returns and US treasury inflation protected securities (TIPS) and global bonds outperformed the broad fixed income market. Looking at the average of five years of previous fourth quarters, we see that a diversified approach to investing added value as small cap stocks outperformed large cap, and value beat growth across the entire market capitalization spectrum. While the averages of the previous five fourth-quarter returns are strong it’s important to realize that these are taken from one of the longest bull markets in history which may be unlikely to continue going forward. As such, holding a diversified portfolio becomes even more important in periods of uncertainty and gives investors the best opportunity to successfully navigate any market environment.

Contributors (+):

• Domestic large cap growth stocks were the greatest contributors; with mid and small cap equity also contributing.
• High yield, bank loans, and emerging market debt, contributed despite the increase in interest rates.
• Growth continued to outperform value, with mid cap growth stocks posting the greatest outperformance relative to their value counterparts.
• Real estate ended the quarter up, on the back of a strengthening US economy.
• Investment grade fixed income was up for the quarter, as short-term bonds fared better than their longer-term counterparts.

Detractors (-):

• Commodities struggled as gold and other precious metals sold off over the quarter.
• While international developed equity generated positive returns, it significantly tailed its domestic counterpart.
•  
• Value stocks continued to struggle relative to growth, marking nearly two years of underperformance.
• Global bonds and US TIPS ended the quarter lower on the back of increased interest rates.

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE GR USD, MSCI EM GR USD, Bloomberg Commodity TR USD, DJ US SElect REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

** Average 4th quarter returns over the trailing five years

Domestic equity markets caught a bid in the second quarter despite trade wars and the threats posed to global growth. A clear divide between the US and the other G7 powers was apparent at the G7 summit which ended with heated remarks, the beginnings of a trade war, and Donald Trump walking out without signing the communique. The US economy grew by 2% in the Q1, below the 2.9% registered in the last three months of 2017. The Federal Reserve (Fed) proceeded with its monetary tightening, increasing the target interest rate range to 1.75%-2.00%, and signaling that two additional increases may be on the way this year. In a rotation from last quarter, US equities were the best asset class performer. As compared to a simple portfolio holding only S&P 500, traditional fixed income and cash, diversification with international equities and fixed income didn’t help in Q2, with international securities prices affected by increased trade tensions and a stronger dollar. However, diversification with small cap equities was positive, as this asset class outperformed large cap equities. Within fixed income, diversification with lower quality debt such as high yield and bank loans was beneficial to performance given the negative returns of traditional fixed income.

Given the strong US stock returns in the past 10 years, one may be compelled to dump all international holdings and invest only in US securities. US equity markets are currently experiencing the third longest bull market in history. However, security returns, as many other statistical measures, are mean-reverting. This means that at some point, US equity returns are expected to drop below their long-term average, taking into account the nine-plus years of extraordinary performance. When that will happen is difficult to determine. As a result, investors should hold diversified portfolios of securities to offset the effects of idiosyncratic market risks and reduce the volatility of their portfolio returns. Holding a diversified portfolio becomes even more important in periods plagued by trade wars, unstable global agreements that threaten global growth and security markets.

Contributors (+):

• Domestic stocks which outpaced developed international and emerging markets equities (affected the most by increased trade tensions and a stronger dollar).
• Small cap stocks, particularly small cap value which outperformed small cap growth.
• High yield and bank loans, which were not affected by the increase in interest rates.
• Growth outperformed value significantly in the large cap space, and less in mid cap stocks.
• Real estate was also unaffected by the Fed interest rate hike.
• Short-term bonds fared better than their longer-term counterparts in a quarter that experienced a further flattening of the yield curve.

Detractors (-):

• Emerging markets debt and equities tumbled during the quarter due to increased selling pressures in the wake of looming trade wars.
• Value stocks continued to trail growth for the sixth consecutive quarter.
• Investment-grade bond values dropped in the quarter resulting from the increase in interest rates.
• Global bonds were affected by intensified trade tensions and the dollar appreciation.

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE GR USD, MSCI EM GR USD, DJ UBS Commodity TR USD, DJ US SElect REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR..

Short of a crystal ball, it is difficult to predict with accuracy the winning and losing asset classes. As such, Harry Markowitz, the pioneer behind Modern Portfolio Theory, advocated the importance of holding a diversified basket of assets to minimize idiosyncratic risks and dampen portfolio volatility. The first three months of 2018 demonstrate that the benefits of diversification remain intact.

At the start of the year, the markets were generally optimistic and equities continued their march higher amid a backdrop of positive economic data and newly passed tax reform. In fact, large cap US equities had one of their best Januaries in years, and if you invested your entire portfolio in the Russell 1000 Growth index, you racked up a solid 7% return. However, by February 5, the Dow Jones plunged more than 1,000 points and the VIX, a measure of volatility, spiked to a reading of 37, sending the majority of asset classes in a downward spiral. Value equities, which tend to hold up better during volatile times, declined more than their growth counterparts, while fixed income, generally a safe haven for investors, also saw negative February returns. March was mixed, with small cap equities bouncing back, while large cap growth continued to sell off. Fixed income stabilized. REITs reversed course to become one of the best performing asset classes for the month. Revisiting an original investment in all large cap growth equities at the end of the first quarter would have returned 1.42%, better than a portfolio of all US intermediate bonds but worse than a portfolio invested in all US small cap growth stocks. Asset class leaders changed rapidly during the quarter, and timing exposures, which is an extremely hard activity at any point, would have proven increasingly difficult. Maintaining a diversified portfolio throughout the quarter resulted in varying degrees of volatility and returns, ultimately easing their ride.

Contributors (+):

• Small cap growth, which was the best performing domestic equity asset class.
• Growth outperformed (as value fell into negative territory).
• International emerging markets, aided by Latin America and China.
• Bank loans, with the Fed rate hike and corresponding rise of treasury yields.
• Short bond exposure experienced less of a draw down (relative to both equities and other fixed income asset classes).
• Commodities, which outperformed most equities and fixed income asset classes despite a -0.4% return.

Detractors (-):

• International developed market equities (as compared to emerging market equities).
• Domestic fixed income (including intermediate, TIPs, and high yield bonds) which struggled as the 10-year treasury rose by more than 30 bps.
• Value stocks trailed growth for a fifth consecutive quarter.
• Real estate, which struggled in the wake of another Fed hike.

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE GR USD, MSCI EM GR USD, Bloomberg Commodity TR USD, DJ US SElect REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

For returns during previous periods (2017 and 1998-2017), please scroll below for Q4 2017 Diversification Scorecard.

Over the past 90+ years, stocks have provided the highest returns, but with much greater risk. A diversified combination of stocks and bonds can help smooth out unsystematic risk in a portfolio so that the positive performance of some investments can offset the negative performance of others.

Download the full chart.

Equity markets continued their strong performance, closing out 2017 with another quarter of gains, buoyed by continued investor optimism and several positive developments that pushed the rally to its current record level. A $1.5 trillion tax reduction bill was signed into law. Third-quarter US GDP was reported at 3.2%, the fastest pace of growth since Q1 2015, and a second consecutive reading over 3%. During quarters of strong equity returns like Q4, when markets are dominated by a risk-on attitude, diversification may seem to not offer much value. However, over full market cycles, diversified portfolios can weather volatile markets and enjoy a smoother ride. Diversified portfolios with exposures to international and emerging markets benefited from those asset classes' strong 2017 performance. Investors would be well-served in 2018 to continue their focus on maintaining diversified portfolios, as other diversifying asset classes have the potential to follow the trend and provide strong comparable returns.

Contributors (+):

• International equity and emerging markets exposure
• Commodities exposure, due to a weaker dollar and a surge in oil prices in Q4 and copper prices in December.
• Large cap exposure (especially growth stocks), which largely outpaced small cap.
• Mid cap growth exposure
• Diversification in fixed income; the search for yield and weaker dollar enhanced returns in high yield, bank loan, int'l bond.
• EM debt, which outpaced intermediate bonds on the quarter and full year.

Detractors (-):

• Fixed income exposure, as modest gains widely trailed that of equity peers in a market focused on rewarding equity risk.
• Value stocks, which trailed growth in both Q4 and full year.
• Despite adding value in Q4, commodities served as a detractor on the full year.
• Real estate, which struggled in the growth-fueled rally.

* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE GR USD, MSCI EM GR USD, DJ UBS Commodity TR USD, DF US Select REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.

Diversification is intended to smooth out unsystematic risk in a portfolio so that the positive performance of some investments will help offset the negative performance of others. We experience this phenomenon every year.

Download the Asset Class Returns: 20-Year Snapshot and the Fixed Income Asset Class Returns: 10-Year Snapshot.

Despite the challenging political landscape in Washington during President Trump’s first year in office and the geopolitical uncertainty throughout the world, financial markets were relatively calm, and delivered solid gains, in 2017. The strong performance was broad-based, with positive contributions coming from asset classes and market segments that had been relative laggards for several years. Portfolios that were constructed to be well-diversified going into 2017 benefited from this environment. Investors will be well-served in 2018 to continue their focus on maintaining diversified portfolios, as the trends making diversification beneficial in 2017 are likely to continue over the next 12 months.

Read the full article on WealthManagement.com.

One of the most important concepts taught to MBA students in Investments 101 is that portfolio diversification is fundamental to a sound investment strategy. In 1952, Harry Markowitz, pioneer of Modern Portfolio Theory, coined the oft-cited phrase, “Diversification is the only free lunch” in finance. Diversification has earned this reputation because of its ability to produce superior risk-adjusted returns over time.

Read the full commentary.

Over the past few years, diversified portfolios have posted only modest results, as they struggled to keep pace with the more narrowly focused but high profile large-cap domestic equities. However, four months into 2016 has shown that diversification may still be beneficial. Several asset classes that struggled the past few years have finally shown some life, leading markets higher and underscoring the advantages of diversifying your asset allocation.

Read the full commentary.

PMC portfolios are risk based, fully diversified solutions designed for a broad range of investors. Contact us to learn more.

This commentary is provided for educational purposes only. The information, analysis and opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed. Past performance is not indicative of future results.