Diversification

Is Diversification Working?

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.
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• 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.