Diversification

Is Diversification Working?

Diversification Scorecard: Q1 2024
April 19, 2024

It was another tough quarter for diversification, with many of the trends from the previous quarter persisting into the first quarter of 2024. Despite shifts in anticipated interest rate cuts, geopolitical tensions, and regional economic challenges, global equity markets continued to rise in Q1, particularly within the U.S. The S&P 500 Index gained 10.6% over the quarter hitting record highs and posting its best first quarter since 2019. Four of the Magnificent 7 stocks continued their charge through the first quarter, with Nvidia (NVDA) leading the way +82%. However, the U.S. also witnessed a broader market rally beyond mega-cap technology stocks, supported by continued resilience in the economy amid strong corporate earnings and positive labor and GDP reports. As was widely expected, the Federal Reserve kept its key federal funds rate unchanged (for the fifth straight meeting) at a range of 5.25-5.50% and indicated they still expected three rate cuts in 2024. Fed Chair, Jerome Powell, stated that inflation continues to trend towards the Fed’s 2% target, but that this sometimes follows a “bumpy path,” warning that the timing of those reductions was still to be determined. The 10-year U.S. Treasury yield increased steadily from 3.88% at the end of 2023 to 4.20% by the end of March 2024, affecting various bond sectors negatively.

On the equity side of the equation, most diversifying asset classes failed to keep pace with the strong returns of the S&P 500 Index and large cap equities in general, save for large cap growth stocks, specifically, with the Russell 1000 Growth Index returning 11.41%. But it's worth noting strong returns were witnessed within large cap value equities as well, with the Russell 1000 Value Index returning 8.99%, and across mid cap stocks, with the Russell Mid Cap Growth Index returning 9.50% and the Russell Mid Cap Value Index returning 8.23%. While small cap growth stocks also posted meaningful returns, small cap value stocks lagged, with the Russell 2000 Value Index returning only 2.90% compared to 7.58% for the Russell 2000 Growth Index. 

Commodities also failed to keep pace with large cap equities in the first quarter, gaining only 2.19%, but have been an interesting asset class to watch from a diversification perspective over the past few years. We witnessed commodities lead asset class returns in 2021 and 2022, but post losses in 2023 when most other asset classes experienced strong gains. Energy sector ebb and flows have been top of mind for many, especially amid rising tensions in the Middle East, but the more interesting story may be gold’s somewhat unexpected rise to record highs in recent months. 

The precious metal, traditionally viewed as a safe-haven asset during periods of economic and geopolitical uncertainty, saw its price top $2,000 an ounce in Q1 2024, reaching all times highs. Gold is also widely viewed as a hedge against inflation and depreciating currencies.

¹ 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, Bloomberg US Agg Bond TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, Bloomberg Gbl Agg Ex USD TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR, Bloomberg Municipal TR USD

² Diversified portfolio: 30.6% Russell 3000 TR; 16.6% MSCI ACWI Ex US NR; 23.80% Bloomberg US Gov/Corporate Intermediate TR; 15% HFRX Global Hedge Fund; 6.7% Bloomberg Gbl Aggregate Ex US TR; 3.8% Bloomberg Commodity; 1.5% Bloomberg High Yield Corporate TR; 2% FTSE Treasury Bill 3 Months.

Diversification Scorecard: Q4 2023
January 18, 2024

In the year of the magnificent-7 stocks leading the charge higher for equities, it has been challenging to champion the benefits of diversification. High growth tech and AI-fueled exuberance helped to power this hyper-concentrated list of stocks up 107% in 2023, often leading many who track the S&P 500 Index wondering, “What about the other 493 stocks? What about other asset classes outside of large cap growth? Does diversification still matter?” The one constant with markets is that they are continuously changing, and the leadership of the past seldom remains at the top. Even now, large cap stock leadership broadened out in December 2023 and into the early days of 2024. 

Behind the most anticipated recession not coming to fruition and the soft-landing scenario seeming most likely, as well as multiple potential rate cuts on the horizon, global markets cheered into the holiday season. The fourth quarter provided robust broad-based gains across equities and bonds, helping to boost the full year returns across asset classes. However, diversification receives a mixed report card in the fourth quarter and over the full year. 

In Q4, the S&P 500 Index gained 11.69% and the Bloomberg US Aggregate Bond Index gained 6.82%. While there were gains to be had across other asset classes, they generally lagged these returns at a broad level. The main exceptions to this include small cap equities, with the Russell 2000 Index returning 14.03%, global bonds, with the Bloomberg Global Aggregate Bond ex USA returning 9.21%, and high yield, with the Bloomberg Corporate High Yield Index returning 7.16%. Areas that did not fully keep pace but still delivered above average returns include international developed, with the MSCI EAFE Index returning 10.42%, and emerging markets, with the MSCI EM Index returning 7.83%. On the lower end of the return spectrum, liquid alternatives trailed, with the HFRX Global Hedge Fund Index returning 1.70% and commodities posted losses, with the Bloomberg Commodity Index down 4.63%. 

At the portfolio level, diversification results struggled in Q4 and 2023. A basic 60/40 portfolio which combines the S&P 500 Index and the Bloomberg U.S. Aggregate Bond Index returned 9.74% in the fourth quarter, widely outpacing a fully diversified portfolio including many asset classes, which returned 7.23%. The returns widen out further over 2023’s full year, resulting in a difference of 536 basis points, 17.99% compared with 12.63%. However, this will likely not always be the case. 
 

 * 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, Bloomberg US Govt/Credit Interm TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, Bloomberg US Treasury US TIPS TR USD, Bloomberg Gbl Aggregate Ex US TR USD, JPM EMBI Global TR USD, Morningstar LSTA US LL TR USD, HFRX Global Hedge Fund. 

Diversification Scorecard: Q3 2023
October 17, 2023

Despite a positive first half of the year, the third quarter saw major market segments within global equities and fixed income indexes sell off, ending the quarter in negative territory. The turbulent period was marred by rising interest rates, as the federal funds rate target increased by 0.25% to a range of 5.25% to 5.50%, and negative sentiment that resulted in added selling pressure. The negative investor sentiment was driven by slowing economic growth, the negative impact from the recent oil price increases, and the likely reduction in consumer spending that will result from the resumption of student loan payments. Those factors combined with the narrowly averted government shutdown and cracks in China’s economy. 

Domestic equity markets, represented by the Russell 3000 Index, returned -3.25%, whereas international equity markets posted slightly weaker results, with the MSCI ACWI Ex USA Index returning -3.77%. Fixed income indexes performed in line with equities over the quarter, as domestic fixed income securities, represented by the Bloomberg US Aggregate Bond Index, returned -3.23%, narrowly outperforming the Bloomberg Global Aggregate Bond Index, representing global fixed income, which returned -3.59%. 

Diversification benefited investors over the third quarter with several diversifying asset classes adding value, as a simple portfolio invested 60% in the S&P 500 Index (down 3.27%) and 40% in the Bloomberg US Aggregate Bond Index (down 3.23%) underperformed a more diversified portfolio. More specifically, emerging markets (-2.93%), commodities (4.71%), liquid alternatives (0.75%), short-term debt (0.73%), high yield (0.46%), and bank loans (3.46%) were constructive to relative performance in the third quarter.The quarter was a good case study for the benefit of diversification, in a period where both bonds and stocks generally returned similar negative performance, diversifying asset classes provided an important ballast for overall portfolio returns. This benefit is the result of thoughtful portfolio construction, which combines a variety of assets classes whose returns are less than perfectly correlated, delivering a portfolio that should reduce volatility of returns over the long run. To highlight one important diversifier, liquid alternatives, as represented by the HFRX Global Hedge Fund index returned a positive 0.75%, during a challenging third quarter.  

* 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, Bloomberg US Agg Bond TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, Bloomberg Gbl Agg Ex USD TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR, Bloomberg Municipal TR USD

Diversification Scorecard: Q2 2023
July 17, 2023

U.S. large cap equities continued to charge higher in the second quarter, leaving behind most asset classes. The S&P 500 Index soared 8.7% in the second quarter, contributing to a substantial gain of 16.9% for the first half of the year. Similarly, the tech-focused Nasdaq had an impressive performance, surging by 13.1% in the second quarter and achieving a remarkable 32.3% gain for the first half, marking its strongest first half since 1983. The impressive gains in the indices were largely propelled by a select few mega-cap tech stocks, driven by the enthusiasm surrounding Artificial Intelligence (AI). Many view AI as a potentially transformative technology, offering companies additional sources of growth, much like the internet did. Smaller and mid-cap stocks, as well as international equity indices, with less emphasis on technology, delivered more modest returns. Safe-haven assets struggled, while riskier assets performed well. Treasuries and most bond sectors posted negative returns. On the equity side, the defensive sectors – Utilities, Consumer Staples and Health Care – posted negative returns overall, lagging Information Technology and Consumer Discretionary sectors by a wide margin. The rise in interest rates typically poses a risk to businesses with long-term profit projections, but this didn't seem to impact growth equities in the U.S., which outperformed value stocks. Internationally, the opposite trend was observed. With the market largely disregarding negative longer-term economic views, one may question if we are entering an AI-driven stock market bubble.

At the beginning of 2023, diversification was a key consideration for investors as stock dispersions increased and different asset classes followed divergent paths. In an environment characterized by high inflation and rising interest rates, the search for assets with sustainable growth became crucial. However, the AI euphoria delivered a setback to diversification in Q2 and throughout 2023. As shown in Table 1, growth companies, particularly large-cap growth stocks, have dominated with double-digit returns year-to-date, while other asset classes have experienced more modest mid-single-digit returns.

For investors with diversified portfolios, this has translated into quarterly and first-half returns that have been more modest compared to the flamboyant returns of large cap stocks. Rising interest rates and yields have inflicted pain across all sectors of the fixed income markets, although the buoyant investor sentiment has provided some support to lower quality issues. Cooling energy prices and weakening global manufacturing demand have negatively impacted commodities. Additionally, real estate has also been affected by the rise in interest rates, mirroring the challenges faced by 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, Bloomberg US Agg Bond TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, Bloomberg Gbl Agg Ex USD TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR, Bloomberg Municipal TR USD

Diversification Scorecard: Q1 2023
April 13, 2023

Global markets posted positive returns to start 2023, despite several bank failures, global central banks continuing to tighten financial conditions to combat inflation, economic uncertainty, and geopolitical tensions remaining elevated. The Federal Reserve continued on its path of fighting inflation, albeit at a reduced pace of increases, with two 25 basis points hikes in the first quarter, bringing the Fed Funds Rate to a range of 4.75-5.00%. Since March 2022, the central bank has increased the Fed Funds rate by 475 bps. Markets proved resilient with both equities and bonds posting solid gains in Q1.

The benefits of diversification were mixed in the first quarter of 2023, with not much benefit amongst equity allocations, while allocating amongst fixed income asset classes added value. The S&P 500 gained +7.5% in Q1, driven heavily by strong performance of technology stocks. International developed posted strong results, outpacing domestic equities, with the MSCI EAFE Index returning +8.5% vs. 7.2% for the Russell 3000 Index. Emerging market equities trailed, returning +4.0%, with relative weakness from China, India, and Brazil holding back strong results from Taiwan. Large cap stocks outperformed small cap stocks, with the Russell 1000 Index returning +7.5% vs. +2.7% for the Russell 2000 Index, as regional bank weakness drove small cap underperformance. Growth stocks widely outperformed value stocks in Q1, with the Russell 1000 Growth +14.4% vs. Russell 1000 Value +1.0%, a difference of 1,336 basis points. Equity performance was heavily driven by a concentrated list of names, as five companies, Apple, Microsoft, Alphabet, Amazon, and Nvidia, comprised nearly 2/3 of the 7.5% gain for the S&P 500.

Commodities posted a loss in the first quarter, returning -5.4% in Q1, on weakness across energy, specifically natural gas and crude oil. Real Estate struggled when compared to broad equities. Liquid alternatives underperformed, given the equity and fixed income strength, with the HFRX Global Hedge Fund Index returning 0.0%.

Fixed income returns were positive to start the year and experienced stronger diversification benefits when compared against broad equity exposure. The Bloomberg US Aggregate Bond Index returned +3.0%, outpacing the Bloomberg US Government Credit Intermediate return of 2.3%. Investment grade corporate bonds were mostly in-line with high yield, with the Bloomberg Investment Grade (IG) Corp Bond Index returning +3.6% compared to +3.6% for the Bloomberg US Corp HY Index. The 10-Year Treasury Yield moved lower to 3.49% at quarter-end, 39 bps below its 2022 year-end yield of 3.88%. International fixed income slightly outperformed domestic, with the Bloomberg Global Aggregate ex US returning +3.1%. Bank loan exposure was also additive to results, with a 3.2% gain for the Morningstar LSTA US Leveraged Loan 100 Index. Emerging market bonds posted a gain of 2.3%, slightly trailing intermediate-term 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, Bloomberg US Govt/Credit Interm TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, Bloomberg US Treasury US TIPS TR USD, Bloomberg Gbl Aggregate Ex US TR USD, JPM EMBI Global TR USD, Morningstar LSTA US LL TR USD, HFRX Global Hedge Fund. 

Diversified portfolio: 30.6% Russell 3000 TR; 16.6% MSCI ACWI Ex US NR; 23.80% Bloomberg US Gov/Corporate Intermediate TR; 15% HFRX Global Hedge Fund; 6.7% Bloomberg Gbl Aggregate Ex US TR; 3.8% Bloomberg Commodity; 1.5% Bloomberg High Yield Corporate TR; 2% FTSE Treasury Bill 3 Months.

Diversification Scorecard: Q4 2022
January 18, 2023

In a reversal from the three previous quarters, markets finally saw positive gains in the fourth quarter of 2022. Quarterly gains were driven by strength in October and November, which helped to offset December weakness and end a streak of three straight quarters of losses in 2022. The S&P 500 Index gained 7.5% in the quarter. Fixed income posted modest gains, with the Bloomberg US Aggregate Index returning 1.87%. The Federal Reserve continued to fight high inflation, raising the feds fund rate twice in the quarter. The Fed raised rates by 50 basis points following December’s FOMC Meeting, bringing the key rate to a range of 4.25% to 4.50%. The 50 bps hike was a shift from the previous four consecutive 75 basis point increases this year. Though the Fed slowed the pace of its hikes, its overall tone remained hawkish. While hiring slowed slightly, employment continued to be resilient with employers adding 223,000 jobs in December and the unemployment rate falling from 3.6% to 3.5%. Despite high inflation, rising rates, and slowing employment growth, the US economy posted modest growth over the quarter. The Bureau of Economic Analysis released the third estimate of Q32022 real GDP which came in at 3.2%, slightly higher than the prior estimate of 2.9%, and higher than the 0.6% decrease seen in the previous quarter.

Diversification proved to be beneficial overall in Q4, with international developed and emerging markets shining as the main contributors for diversifying equity and fixed income asset classes. The MSCI EAFE Index returned a whopping 17.34% over the quarter and the MSCI EM Index returned a solid 9.70%, both outperforming domestic equities. On the fixed income side, the Bloomberg Global Aggregate Ex US Index and JPM Emerging Market Bond Index Global returned 6.81% and 7.44%, respectively, considerably outpacing the Bloomberg Aggregate Bond Index. Value outperformed growth significantly as well in Q4 and across all market caps, with the Russell 3000 Value Index gaining 12.18% vs. 2.31% for the Russell 3000 Growth Index. High yield and Banks loans also contributed as diversifying fixed income asset classes with the Bloomberg US Corporate High Yield Index and Morningstar LSTA US LL Index retuning 4.17% and 2.74% over the quarter, respectively.

On the full year, results were decidedly less rosy for the markets, with equity and fixed income posting negative returns across the board, closing out the year down significantly. All three major US indexes posted their worst year since 2008, ending a three-year positive streak. The Dow Jones Industrial Average fared the best, losing -6.86%, followed by the S&P 500 Index which lost -18.11%, while the tech-heavy NASDAQ Composite fell -32.54%.

 * 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, Bloomberg US Govt/Credit Interm TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, Bloomberg US Treasury US TIPS TR USD, Bloomberg Gbl Aggregate Ex US TR USD, JPM EMBI Global TR USD, Morningstar LSTA US LL TR USD. 

Diversified portfolio: 30.6% Russell 3000 TR; 16.6% MSCI ACWI Ex US NR; 23.80% Bloomberg US Gov/Corporate Intermediate TR; 15% HFRX Global Hedge Fund; 6.7% Bloomberg Gbl Aggregate Ex US TR; 3.8% Bloomberg Commodity; 1.5% Bloomberg High Yield Corporate TR; 2% FTSE Treasury Bill 3 Months.

Diversification Scorecard: Q3 2022
October 12, 2022

The third quarter was a turbulent period, as equity and debt securities moved in tandem, both rallying to multimonth highs in August, only to end the period with negative results. Domestic equity markets, represented by the Russell 3000 Index, returned -4.46%, whereas international equity markets posted greater losses, with the MSCI ACWI Ex USA Index returning -9.91%. Fixed income posted similar performance over the quarter, as domestic fixed income securities, represented by the Bloomberg Barclays US Aggregate Bond Index, returned -4.75%, outperforming the Bloomberg Barclays Global Aggregate Bond Index, representing international fixed income, which returned -6.94%. 

The selling over the back half of the quarter resulted from significant de-risking by market participants, as fears of global economic recession increased. In international markets, Europe saw record-level energy prices, placing a serious strain on economic activity and adding to inflationary pressures. On a domestic basis, the Federal Reserve (Fed) communicated further aggressive interest rate increases as it struggled to control persistently high inflation. In each of the July and September Federal Open Market Committee meetings, the Fed decided to increase the federal funds rate by 75 basis points.

Several diversifying asset classes underperformed over the third quarter, and a simple portfolio invested 60% in the S&P 500 Index (down 4.88%) and 40% in the Barclays US Aggregate Bond Index (down 4.75%) likely outperformed a more diversified portfolio that included other asset classes, such as large cap value (down 5.62%), international developed (down 9.29%), emerging markets equity (down 11.57%), and international fixed income (down 6.94%).  There were bright spots among diversifying asset classes, such as; bank loans (up 1.37%), small & mid growth (up 0.24% and down 0.65%), and high yield bonds (down 0.65%) that outperformed the simple portfolio.

When reviewing the longer year-to-date period, market performance is particularly bad, with double-digit losses for both equity and fixed income indices. In fact, during historic nine-month rolling periods, equity market performance has not been this bad since the Global Financial Crisis in 2008, and fixed income indices are posting some of their worst performance in history. Although previous bear markets have experienced greater drawdowns, what makes this bear market so painful is the simultaneous drawdowns of both equity and 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, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, Bloomberg US Govt/Credit Interm TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, Bloomberg Gbl Agg Ex USD TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR, Bloomberg Municipal TR USD

Diversification Scorecard: Q2 2022
July 13, 2022

With US equities crushing international stocks and most other asset classes in recent years, some investors have questioned conventional investing wisdom:  whether diversification plays a role in their portfolios. And, as 2022 progressed, volatility reigned supreme, putting investors’ fortitude to a test. Stubbornly high inflation, sharp increases in interest rates, rising recession risks, ongoing geopolitical unrest, and a massive COVID-related lockdown in China have pressured equities and other assets. The sharp drop in China’s economic activity not only increased the chances of a global recession, but also compounded global supply chain problems. The May Consumer Price Index (CPI) report showed inflation had not yet peaked, as the CPI rose 8.6% year-over-year, the highest reading since 1982. In response to the recent high readings, the Federal Reserve (Fed) hiked interest rates twice in the quarter, for a total of 125 basis points, to a level of 1.50%-1.75%. Sticky inflation combined with the greater-than-expected rate increases sent equities into a spin, with the S&P 500 Index experiencing its worst first half of the year in decades. International equities showed more resiliency than domestic stocks in Q2, however, with emerging and international developed markets dropping less than US equities. Large caps fared slightly better than small caps, whereas value stocks handily outpaced growth. Despite commodities registering negative returns in the second quarter, mostly as a result of steep declines in late June, they outperformed equities by a wide margin. 

Within fixed income markets, most bond indices registered solidly negative returns, as still-high inflation and the prospect of faster-than-expected rate increases from the Fed weighed on most fixed income sectors. In response to a hawkish Fed and elevated CPI readings, Treasury yields surged to levels last seen more than a decade ago, with the yield on the 2-year U.S. Treasury Note ending the quarter six basis points lower than the 10-year’s 2.98% yield. The yield curve flattened as a result, with investors worrying that the sharp increase in rates may hamper economic growth. Domestic bonds significantly outperformed their global counterparts. Long duration bonds trailed shorter duration issues, and investment grade outperformed lower-quality, higher-yielding bonds. Municipals performed better than taxable bonds, thanks in part to a positive technical and fundamental backdrop. 

Did diversification help dampen portfolio volatility in Q2? Table 1 shows that except for short-term municipal bonds, all asset classes faced significant selling pressures in Q2, with equities and global bonds plummeting by double digits. Even commodities, the strongest asset class in Q1, and value equities, which held their ground well in the first three months of 2022, succumbed in Q2. All portfolios have suffered from increased market volatility year to date, as correlations between equities and fixed income asset classes increased at the worst time, creating a perfect storm for investors.

* 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, Bloomberg US Agg Bond TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, Bloomberg Gbl Agg Ex USD TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR, Bloomberg Municipal TR USD

Diversification Scorecard: Q1 2022
April 28, 2022

It was another interesting quarter for diversification, as volatility increased and markets struggled across the board in Q1, with both equity and fixed income falling in tandem. Equity markets closed out their worst quarter in two years, with the major indices all ending Q1 in negative territory, despite the rally seen in late March. Just as the world seemed to show signs of recovery from the pandemic, geopolitical concerns heightened, with the Russian-Ukraine conflict taking a turn for the worse, causing oil to skyrocket. The potential need for a faster pace of interest rate hikes to combat continued elevated levels of inflation also loomed over the markets, as the Federal Reserve raised the federal funds rate by a quarter percentage point to 0.25% - 0.50% at the March FOMC meeting. Though widely expected, this was the first rate hike seen since December 2018. The Fed also appeared to take a decidedly more hawkish tone, indicating it now anticipated rate hikes for each of the remaining six FOMC meetings in 2022. Fears of a recession were also on the rise, with the yield curve flattening over the quarter, and the 2-year and 10-year Treasury yields inverting, on the last day of the quarter, for the first time since 2019. The S&P 500 Index lost 4.60% in Q1, though not nearly as much as its 19.60% decline in Q12020, at the beginning of the pandemic. Whereas investors were able to flee to the safe haven of fixed income in Q12020, that was not the case this quarter, with most fixed income asset classes posting similar negative returns to equities.

The economy, nonetheless, continued to show signs of growth. In March, The Bureau of Economic Analysis released the third estimate of Q42021 real GDP, which came in at an impressive 6.9%. This was revised down just 0.1 percentage point from the prior estimate of 7.0%, but still higher than the 2.3% increase seen in the previous quarter. Overall, the US economy grew at a pace that was stronger than expected in 2021. In fact, it was its fastest calendar year pace since 1984, expanding by 5.7%, compared with a 3.4% decline in 2020. Not surprisingly, however, Q1 GDP data is forecast to be down compared with Q4. Employment continued to surprise on the upside as well, with total nonfarm payroll employment rising by 431,000 in March, and the unemployment rate falling to 3.6%, down from 3.8% in February. Notably, job gains continued in leisure and hospitality, professional and business services, retail trade, and manufacturing. Overall, unemployment was only slightly higher than the prepandemic level of 3.5% seen in February of 2020. 

* 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, Bloomberg US Agg Bond TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, Bloomberg Gbl Agg Ex USD TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR, Bloomberg Municipal TR USD

Diversification Scorecard: Q4 2021
January 13, 2022

The 2021 diversification story was an interesting one. Potential sparks of volatility arose from spiraling inflation that turned out to be less than “transitory,” pandemic variant outbreaks, supply chain bottlenecks, and fits and starts with the global economy. Despite these challenges, the equity market trend remained steadfast on a move higher for US large cap stocks, with the S&P 500 Index reaching record highs 70 times throughout the year, the most record highs since 1995. Immense COVID-19-induced monetary and fiscal stimulus continued to support equities. Some risk assets rocketed higher, others exceeded expectations, whereas several left diversified investors craving higher returns. 

The S&P 500 Index finished with a gain of 28.71% and failed to pull back more than 5% throughout the year, highlighting the overall lack of volatility. Outside of domestic stocks, the trend remained positive but decidedly less bullish for international and emerging markets equities, with the MSCI World ex USA Index gaining 12.62%. Emerging markets were a large area of weakness in the diversification story, dragging down results within a 60/40 portfolio, as weakness in China drove negative investor sentiment on the asset class, which translated to a loss of 2.54%. Core bond investors suffered a losing year in 2021, with the Bloomberg US Aggregate Bond Index posting a loss of 1.54%, only the fourth time it posted a negative return in the past 45 years. Most diversified portfolios experienced strong gains far exceeding their long-term targets. But in such a strong year for the S&P 500 Index, in which it gained nearly 30%, many investors were left behind, as diversification struggled to keep pace with fast money returns. 

Aside from the domestic large cap equity rally in 2021, several pockets of success across diversifying asset classes are worth highlighting. Commodities, one of the most unloved areas of the market in the last decade, experienced a flood of investors amid increased demand and supply constraints, resulting in surging goods and energy prices. The Bloomberg Commodities Index gained 27.11% for the year, outperforming equities in each of the first three-quarters of the year before a weaker fourth quarter. Small caps gained 14.82% on the Russell 2000 Index, an otherwise great year except when compared against large cap. Real Estate also experienced a strong year, with the DJ US Select REIT Index gaining 45.91%. 

* 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, Bloomberg US Agg Bond TR USD, Bloomberg US Govt/Credit 1-3 Yr TR USD, Bloomberg US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, Bloomberg Gbl Agg Ex USD TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR, Bloomberg Municipal TR USD

Diversification Scorecard: Q3 2021
October 14, 2021

From a global equity market perspective, the third quarter was a reversal in trend, marking the first negative-performing quarter since the outbreak of COVID-19 in the first quarter of 2020. Domestic equity markets, represented by the Russell 3000 Index, returned -0.10%, whereas international equity markets posted greater losses, with the MSCI ACWI Ex USA Index returning -2.99%. Fixed income fared better over the quarter, as domestic fixed income securities, represented by the Bloomberg US Aggregate Bond Index, returned 0.05%, outperforming the Bloomberg Barclays Global Aggregate Bond Index, representing international fixed income, which returned -0.88%.

Most of the quarterly losses came within the month of September, as a broad sell-off of equities came on the back of increased expectations of reduced asset purchases by the Federal Reserve (Fed), and fear of the economic impact of Evergrande, China’s second-largest property developer, struggling to service its debt. Further market sell-off was triggered at the end of the month, as Treasury Secretary, Janet Yellen, warned of a government shutdown should the debt ceiling not be raised by October 18.

Diversification did not add value over the third quarter, as a simple portfolio invested 60% in the S&P 500 Index (up .58%) and 40% in the Bloomberg US Aggregate Bond Index (up 0.05%) outperformed a more diversified portfolio that included other asset classes, such as large cap value (down 0.78%), emerging markets equity (down 8.09%), small cap growth (down 5.65%), international fixed income (down 0.88%), and emerging markets bonds (down 0.53%).

Although many diversifying assets did not add value over the third quarter, one of the best-performing asset classes was commodities, posting a sharp increase of 6.59% in the quarter, whereas equities and fixed income returns were flat or slightly lower. Commodities are up 29.13% year to date, and have increased 42.29% over the trailing 12 months. In Q3, higher inflation concerns and increased demand helped to drive prices higher. Soft commodities led with a gain of 17.43%; natural gas prices surged 60.74%, pushing energy higher; whereas precious metals were the worst performer, with a loss of 14.61%. In 2021, energy has led the commodity move higher, with a 64.07% increase. For many years, commodities have served an important role within portfolios, providing both diversifying benefits and inflation protection.

* 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, Barclays Municipal 1Year Index, Barclays Municipal Long Index, 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 2021
July 21, 2021

The US economy continued to recover in the second quarter, as widespread vaccine distribution allowed many domestic businesses to reopen. The uptick in economic momentum pushed risk assets higher, with many equity indices reaching new highs, capping one of the best first-half-year gains for the market this century. Domestic equities continued to outperform international, led by large caps, which reversed the recent trend and outperformed small cap stocks. Growth equities rallied, outperforming value in April and June to conclude the quarter as the clear winners, reversing the trend of the last two quarters. Year to date however, the leadership of small cap and value equities remains intact. Similar to domestic stocks, international equity markets continued their recovery that began last year, posting positive returns for the quarter, albeit more muted than those of domestic equities. International developed markets led the way, whereas emerging markets stocks slowed the pace, posting lower returns. 

At its June FOMC meeting, the Federal Reserve acknowledged rising inflation pressures and discussed tapering the purchase of securities sooner than expected. That pushed investors dramatically away from value, cyclicals, small caps, and international stocks and toward large cap growth instead. The sharp rise in yield in the first three months of the year paused during the second quarter, with the yield on the 10-year U.S. Treasury Note ending the quarter at 1.45%. Thus, most of the bond sectors that struggled in the first quarter recovered. High yield bonds, which were the clear winner in the first quarter, continued to post gains, but ended the quarter behind investment grade issues. Long-dated Treasurys performed best, outpacing shorter-duration bonds. Within municipals, long-dated issues were bid during the quarter, with their returns surpassing those of shorter-term issuances. Commodities were one of the best-performing asset classes, ahead of the return of many major equity indices, and significantly contributing to the relative returns of the portfolios that hold them. 

How have diversified portfolios fared so far this year? The first quarter of 2021 was characterized by a spike in volatility, caused primarily by a jump in yields on the heels of an improving economy that is continuing to reopen, along with fears of rising inflation. Despite the weakness in some economic indicators in the first two months of the year, the US economy in general continued to expand. As a result, equities moved higher, with many indices reaching all-time highs in the first quarter. Small and midcap stocks outperformed large caps, and value dominated growth. The recently enacted $1.9 trillion package of fiscal stimulus kept the momentum going in the second quarter of the year, with equities continuing to dominate 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, 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, Barclays Municipal 1Year Index, Barclays Municipal Long Index, 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 2021
April 21, 2021

Despite some volatility, equity markets continued to trend higher in Q1, as the global economy stayed on its path of recovery, fueled by vaccine rollouts, the $1.9 trillion US fiscal stimulus package, and continued monetary support. The S&P 500 Index gained 6.17% in Q1. Though gains were lower than the three previous quarters of the market rebound, they remained in stark comparison to the first quarter of 2020, in which the index fell nearly 20% due to the Coronavirus pandemic. Fixed income struggled in Q1, however, posting mostly negative returns. Inflationary concerns led to rising bond yields over the quarter, as many anticipated a Federal Reserve (the Fed) rate hike on the horizon with the improving economy. The yield on the benchmark 10-year U.S. Treasury Note hit a high of 1.74%, up from 0.92% on December 31, 2020. Even so, the Fed reiterated its continued dovish stance at the most recent FOMC Press Conference in March, acknowledging positive economic growth and some minor inflation activity, but maintaining that rates likely would remain unchanged through 2023.

Indeed, the US economy continued to bounce back in the first quarter. The Bureau of Economic Analysis released the third estimate of Q4 2020 real GDP, which came in at 4.3%. This was slightly better than the prior estimate of 4.1%, but considerably lower than the 33.4% increase seen in the previous quarter. Employment also continued to recover over the quarter, with job growth booming in March. Employers added 916,000 jobs in the month of March, twice as many as in February, and the most seen since August. The unemployment rate fell to 6% in March, the lowest seen since its peak in April 2020, but still slightly higher than the prepandemic rate observed in February 2020. 

Diversification produced mixed, but mostly positive, results within equities over the quarter. Value outpaced growth across all market capitalizations for the second consecutive quarter, with the Russell 3000 Value Index gaining 11.89% vs. 1.19% for the Russell 3000 Growth Index. Small cap outpaced large cap once again, with the Russell 2000 Index returning 12.70%, compared with 5.91% for the Russell 1000 Index. Mid cap also outperformed large cap, as the Russell Mid Cap Index gained 8.14% over the quarter. Commodities and REITs exposure contributed to performance, as both slightly outpaced the broad equity market. Exposure to international developed, emerging markets, and growth all detracted from performance over the quarter, with growth lagging across market capitalizations, and the MSCI EAFE and MSCI EM Indexes returning 3.48% and 2.29%, respectively, compared with 6.35% for the Russell 3000 Index. 

Diversification results within fixed income in the first quarter were fairly mixed. Though high yield and bank loans outpaced investment grade, and short-term bonds outpaced intermediate, exposure to international and emerging markets bonds detracted from performance. The BbgBarc Global Aggregate Ex USD Index returned -5.29% over the quarter, and the JPM EMBI Global Index returned -4.74%, compared with -3.37% for the BbgBarc US Aggregate Bond Index. 

Though mixed or less pronounced results from diversification are often observed from quarter to quarter, when we take a step back, we can see how diversification has benefited investors over longer time periods, and in particular, over the course of this pandemic. Large swings have taken place in the market since the global pandemic hit over the past year, and though each asset class has seen ups and downs, on the whole, diversification over the past year has proved largely beneficial. Exposure to most diversifying asset classes was beneficial, with the exception of international developed equities, commodities, and REITs. Over the trailing 12 months, exposure to small cap has been largely beneficial, with the Russell 2000 returning 94.85%, compared with 60.59% for the Russell 1000 Index. Within fixed income, exposure to high yield, bank loans, and emerging markets debt also has been largely beneficial, with the BBgBarc US Corporate High Yield Index, JPM EMBI Global Index, and S&P Leveraged Loan Index returning 23.72%, 20.71%, and 14.29%, respectively, over the trailing 12 months, compared with 0.71% for the BBgBarc US Agg Bond Index. Moving forward, it will be interesting to observe how diversification will fare in the context of the more muted return projections that have been forecast for the upcoming years. 

Contributors (+):

• Domestic outpaced both international developed and emerging markets equities.
• Value outperformed growth across all market capitalizations.
• Small cap outperformed both large and mid cap equities. 
• REITs and commodities slightly outpaced equities for the quarter.
• High yield and bank loans outpaced investment grade bonds; domestic fixed income outpaced global fixed income; short-term bonds outpaced intermediate bonds. 
• Energy and Financials were the strongest-performing S&P 500 Index sectors. 

Detractors (-):

• International developed and emerging markets equities trailed domestic stocks. 
• Growth lagged value across all market capitalizations.
• Large cap trailed both small and mid cap equities.
• International and emerging markets bonds trailed domestic fixed income. 
• Consumer Staples and Information Technology were the poorest-performing S&P 500 Index sectors. 

* 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 EMB

Diversification Scorecard: Q4 2020
January 21, 2021

Markets surged higher to close out November and December of 2020, as several uncertainties facing the markets were resolved, helping to push indices higher. The fourth quarter was centered on the US election and the positive news of effective vaccines for COVID-19. Still, new infection rates rose significantly in the US and Europe over the fourth quarter, signaling that although we can see a light at the end of the tunnel, we are not yet out of the woods. Federal Reserve Chair Jerome Powell indicated that rates would continue to stay at current near-zero levels, and that it would continue to purchase at least $80 billion in Treasurys and at least $40 billion in agency MBS per month until it feels “substantial further progress” has been made toward its goals. The election that many feared as a highly volatile trigger was digested well by market participants, allowing investors to move forward. Amid these developments, investors mostly shrugged off any concerns, absorbed lukewarm economic data, and bid up equities to record highs. We discuss how diversification held up in the fourth quarter and in all of 2020.

In Q42020, diversification was highly beneficial. Within equity allocations, small cap stocks outpaced large cap, with the Russell 2000 Index up 31.37%, compared with 12.15% for the S&P 500 Index. Mid cap also outperformed large cap, with the Russell Mid Cap Index returning 19.91%. International and emerging markets outperformed domestic equities, with the MSCI EAFE Index up 16.05% and the MSCI EM Index up 19.70%, as a weak dollar, suffering its worst Q4 since 2003, pushed investors toward foreign equities. Value outpaced growth stocks, breaking from a longer-term trend, as the Russell 1000 Value Index gained 16.25%, compared with a gain of 11.39% for the Russell 1000 Growth Index. Within fixed income, high yield and global bonds outperformed domestic core fixed income, with the Bloomberg Barclays Corporate High Yield Index gaining 6.45%, and the Bloomberg Barclays Global Aggregate ex U.S. Index gaining 5.09%. These returns were in stark contrast to a more muted return of 0.67% for the Bloomberg Barclays U.S. Aggregate Bond Index.

Full-year results showed that portfolio diversification proved its worth in 2020. Small cap outperformed large cap stocks, emerging markets outperformed developed markets equities, and global bonds outpaced domestic fixed income. Large cap US stocks remained the main focus for investors seeking both appreciation and current returns, with the S&P 500 Index gaining a solid 18.40%. Growth stocks largely outpaced their value peers, with the Russell 1000 Growth Index rising 38.49%, compared with 2.80% for the Russell 1000 Value Index, a massive gap of 3569 basis points. Investors owning some growth stocks, or a mix of growth and value, rather than just the S&P 500 Index, enjoyed positive portfolio performance. High-octane growth stocks were especially in favor, with many single stocks skyrocketing, such as Tesla, which gained 743.44%; Peloton, which gained 434.23%; and Zoom Video, which gained 394.94%. The IPO market surged, with some stocks gaining more than 100% in their opening day of trading. International developed was a laggard relative to domestic stocks, with the MSCI EAFE Index gaining 7.82%. From a fixed income standpoint, the Bloomberg Barclays Global Aggregate Bond Index ex U.S. Index gained 9.20%, compared with 7.51% for the Bloomberg Barclays U.S. Aggregate Bond Index. However, bank loans, corporate high yield, and commodities all lagged from a diversification standpoint, trailing both broad market equities and fixed income. 

As we look forward and ponder the potential for diversification in 2021, it may be worthwhile to check in on the last five years’ trailing returns of diversification, as those results may suggest trends that are set to continue. However, they also may serve to highlight opportunities in asset classes that have trailed and have been overlooked. Over the past five years, the S&P 500 Index has delivered an incredible 15.2% annualized return. That return has been heavily skewed toward growth over value, evidenced by the 21% annualized return of the Russell 1000 Growth Index, compared with 13.26% for the Russell 1000 Value Index, a difference of 774 basis points annually. Although the gap may narrow in the coming years if value comes back in favor, exposure in both areas has benefited investors. International developed has lagged domestic equities, with the MSCI EAFE Index returning an annualized 7.45% return. Commodities, with an annualized return of 1.03%, may be a coiled spring ready to explode higher. Within fixed income, credit has ruled with corporate high yield, bank loans, global bonds, and emerging markets debt outpacing domestic fixed income. Investment grade may be in favor over credit, or it is possible that international and emerging markets bonds will be the top performers in fixed income asset classes moving forward. 

In reviewing 2020 results and thinking about the year ahead, it is important for investors to remain aware of the benefits of diversification, staying focused on their long-term financial plan rather than letting short-term returns dissuade them from their goals.

Contributors (+):

• Growth outperformed value across all market capitalizations.
• Small cap outperformed large cap; mid cap trailed large cap. 
• Domestic equity outpaced international developed. Emerging markets outpaced domestic stocks.
• Investment grade bonds outpaced high yield, and global fixed income outpaced domestic.
• Information Technology and Consumer Discretionary were the strongest S&P 500 Index sectors.

Detractors (-):

• International developed stocks mostly trailed domestic equities.
• Value lagged growth across all market capitalizations.
• REITs and commodities trailed global equity returns.
• Energy, Financials, and Real Estate were the poorest-performing S&P 500 Index sectors.
• Bank loans, emerging markets bonds, and short-term bonds underperformed 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, 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 EMB

Diversification Scorecard: Q3 2020
October 14, 2020

From a global market perspective, the third quarter was largely a continuation of the second quarter’s bounce-back, as equity and fixed income markets continued to rally higher, albeit at a much more subdued rate. Within domestic markets, equities, represented by the Russell 3000 Index, returned 9.21%, whereas fixed income securities, represented by the Bloomberg Barclays US Aggregate Bond Index, returned 0.62%. International markets also posted positive returns, as equity, represented by the MSCI ACWI Ex USA Index, returned 6.25%, and fixed income securities, represented by the Bloomberg Barclays Global Aggregate Bond Index, returned 2.66%. Much of these gains resulted from the continuation of aggressive monetary policy, as the Federal Open Market Committee left the federal funds rate unchanged at a target range of 0% to 0.25%, and signaled to markets that it plans to keep rates unchanged until at least 2023. Further, the phased reopening of the economy, allowing millions of people to return to work, and the resumption of more normal economic activities were a significant boon to markets. Economic growth over the third quarter is expected to exceed 25%. Similarly, the labor situation continues to improve, with an average of approximately 1.3 million jobs added each month of the quarter and unemployment falling to 7.9%. The US has recovered roughly 11.4 million jobs since May, a strong bounce-back in the labor market, but still only a bit more than halfway to the roughly 22 million job losses in March/April. 

Diversification added value over the third quarter, as a portfolio invested 60% in the S&P 500 Index (up 8.93%) and 40% in the Barclays US Aggregate Bond Index (up 0.62%) trailed a more diversified portfolio that included other asset classes, such as large cap growth equity (up 13.22%); emerging markets equity (up 9.70%); lower-quality debt (up 4.60%); international fixed income (up 2.66%); and commodities (up 9.07%). Entering the fourth quarter, the presidential election will be top of mind for market participants, and the period leading up to and following the election is likely to be accompanied by heightened volatility as investors adjust for the unknown. Given the current risks and uncertainty present in the market, the importance of following a diversified investment approach is paramount.

In preparation for the upcoming presidential election, a review of diversification’s value-add is warranted. To measure this value, we calculated diversifying assets’ performance relative to either the S&P 500 Index or the Bloomberg Barclays US Aggregate Bond Index for the previous five election periods. A presidential election period consists of four consecutive quarters, beginning with the third quarter of the election year, and is presented in table 1. As is to be expected, some asset classes experience significant outperformance and underperformance, further emphasizing the importance of allocating to several uncorrelated asset classes. Within the equity ranks, on average, allocating to asset classes such as large cap value, small cap, emerging markets, and REITs benefited investment portfolios. In aggregate, allocating to the diversifying asset classes represented in this study has added value over the previous five presidential election periods. On the fixed income side, allocating toward high yield and emerging markets debt, on average, has been beneficial over the previous election periods, whereas international bonds have detracted the most. The overall impact of all diversifying fixed income asset classes has been slightly negative relative to a single allocation to the Bloomberg Barclays US Aggregate Bond Index. 

As a point of interest, the diversifying assets’ relative performance during the 2000 presidential election period is quite notable, with substantial outperformance from the value equities, REITs, and emerging markets bonds asset classes, whereas growth equities, international equity and bonds, and high yield greatly underperformed. The 2000 election introduced significant commotion into the markets, as the election results were delayed by five weeks due to a recount in Florida. Over the full 2000 election period, a diversified portfolio added significant value over a nondiversified one. Similar to the 2000 election, the upcoming election faces a possibility of delayed results if neither candidate concedes defeat, forcing a wait for a final count/recount of all ballots. If such were the case, the 2000 election period shows that diversification is the best option to weather the market turmoil that may arise in such a scenario.

Although diversification will not remove all risk of loss associated with investing, it has, on average, proven beneficial to investment portfolios over the five previous presidential elections. Furthermore, over the long run, allocating to uncorrelated assets has proved to help minimize portfolio drawdowns during market pullbacks and reduce the overall level of risk. 

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.

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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.

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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.

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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.

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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.