Diversification Scorecard: Q4 2018
January 16, 2019
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.
- 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%
- 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
|Asset Class Returns*
|Large Cap Growth
|Large Cap Value
|Mid Cap Growth
|Mid Cap Value
|Small Cap Growth
|Small Cap Value
|Int'l Developed Markets
|Emerging Market 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.