The 60/40 stock-bond portfolio has been one of the simplest go-to asset allocation choices to capture the diversification benefit. The problem with a typical 60/40 portfolio is that it still exhibits significant volatility and drawdowns during sustained bear markets, or when stocks and bonds are both falling (as in February 2018). For example, a 60/40 (S&P 500/US Treasuries*) portfolio would have seen drawdowns of -17% in 1987, -22% in 2002 and -31% in 2008.
A common approach to reducing this downside risk is to replace part of the stock and bond exposure with an uncorrelated, or negatively correlated, alternative asset, resulting in something like a 50-30-20 or 40-40-20 portfolio. The issue here is the opportunity cost of replacing a familiar asset class like stocks and bonds with a non-traditional asset class – especially when it underperforms stocks and/or bonds.
As Corey Hoffstein at Newfound Research points out, Modern Portfolio Theory (MPT) quantified the benefits of diversification and that has led to investors looking to expand their investment options beyond traditional stocks and bonds. Yet MPT actually says that in an efficient market, all investors should hold the optimal portfolio, say 60/40 for argument’s sake. Beyond that, investors should simply leverage down if they want less risk (ex. 45/30 plus 25% in cash) or leverage up if they are comfortable with more.
This is why WisdomTree’s innovative new ETF (ticker: NTSX) is interesting. They apply 1.5x accounting leverage to a traditional 60/40 portfolio to create exposure equivalent to 90% equities (S&P 500) and 60% bonds (laddered US Treasuries via futures). The idea is similar to that explained by Cliff Asness, co-founder of AQR Capital Management, in 1996. He argued that an “investor willing to bear the risk of 100% equities can do even better with a diversified portfolio”.
Asness used data from 1926 through 1993 to show that a levered 60/40 portfolio (1.55x) exhibited similar volatility to a 100% equity portfolio but had a higher return. Jeremy Schwartz, WisdomTree’s Director of Research, showed that the concept worked even out-of-sample between 1994 and 2018.
The following table compares returns, volatility and drawdowns for portfolios of 100% stocks, bonds and cash to 60/40 and 90/60 portfolios. The 90/60 portfolio is essentially the 60/40 levered up 1.5x, with the 3-Month Treasury Bill rate used as the borrowing rate.
As the table indicates, an investor comfortable with equity like volatility would be better off with the 90/60 portfolio i.e. levered 60/40, which has a higher return than equities.
On the other hand, an investor could also use a 90/60 type product to create a more efficient portfolio. They could allocate two-thirds of capital to it – giving them 60/40 like exposure – and overlay alternative asset classes using part of the remaining capital, ideally dampening volatility and drawdowns.
Crucially, this approach lowers the hurdle rate for the alternative allocation, which now only has to beat the cash return, instead of stocks and/or bonds.
To this end, we thought it would be interesting to compare the performance of a de-levered 90/60 product (allocating 66.7% in order to get 60/40 like exposure) that is overlaid with different alternative assets, including:
- Cash: we use the 3-month US Treasury Bill. Allocating the remaining 33.3% to cash essentially brings the portfolio to a 60/40 equivalent.
- Out-of-the-Money (OTM) Puts: proxied using 5% out-of-the-money puts on the S&P 500 Index**, calculated using publicly available CBOE data.
- Market Neutral: proxied using the Fama-French High minus Low (HML) portfolio, which goes long the cheapest stocks (highest book-to-market) and short the most expensive stocks (lowest book-to-market).
- Managed Futures: proxied using the Credit Suisse Managed Futures Index.
- Gold: monthly returns calculated using Gold’s fixing price (3pm London time), based in US dollars.
The following table shows the correlation of the above assets with stocks (S&P 500) and bonds (US Treasuries) from January 1994 through June 2018.
All these alternative assets have minimal, or negative, correlation with stocks and bonds, except Managed Futures, which has a 0.30 correlation to bonds. So they would clearly work well as diversifiers to stocks and bonds.
Next we look at the portfolio impact of overlaying these alternative assets onto a de-levered 90/60 portfolio. Below is a chart showing the hypothetical growth of $1, split as follows:
- 66.7% is invested in a 90/60 portfolio (giving 60/40 equivalent exposure).
- 33.3% in a combination of Cash and the alternative asset.
For the baseline case, the remaining 33.3% is held in Cash – which essentially gives you the 60/40 portfolio (note that fees and other expenses have been excluded). For OTM Puts, 5% of the portfolio is invested in them and the remaining 28.3% in Cash. For Market Neutral, Managed Futures and Gold, 20% of the portfolio is invested in each of these and the balance 13.3% is held in Cash.
As the chart indicates, Gold has worked as the best diversifier since 1994. Not unexpectedly, a portfolio with OTM Puts would have performed the worst. Combining Managed Futures with a de-levered 90/60 has not fared much better either over the period we studied, while an overlay of Market Neutral performs just as well as keeping the remaining portfolio in cash, i.e. the standard 60/40.
Using OTM Puts or Managed Futures does result in a lower maximum drawdown (-17.2% and -18.4%, respectively) than a 60/40 portfolio (-30.6%). However, as the following table illustrates, this comes at a significant price i.e. lower returns. A 60/40 portfolio saw an annualized return of 8.0% between January 1994 and June 2018, whereas a de-levered 90/60 portfolio overlaid with OTM Puts or Managed Futures would have seen returns of 4.9% and 6.7%, respectively.
At the same time, the portfolio with Managed Futures sees the lowest volatility, resulting in a higher risk-adjusted return (Sharpe ratio) than 60/40 and every other strategy tested. The strategy with the Gold overlay also showed a higher Sharpe ratio than 60/40 i.e. its higher volatility was compensated for with a higher return.
So which is the best diversifier of them all?
Interestingly, the Market Neutral overlay strategy closely tracked 60/40 by way of returns and volatility, but with a slightly larger maximum drawdown. Note that we chose the Fama-French HML portfolio as our Market Neutral proxy, but we could have selected from a plethora of available strategies and funds in this category and gotten a different result. Same with Managed Futures.
With respect to Gold, the period we chose to study (1994-2018) has seen Gold outperform several other alternatives, but this may not always be the case. Repeating our study for the seven years between 1987 and 1993 actually sees the Gold overlay strategy underperforming Market Neutral and Cash (which comes out on top). Data for the Managed Futures Index was unavailable for this period.
Gold is attractive because of its historical low correlation to stocks and bonds. Yet Gold saw drawdowns as large as -25% in 2008 (based on monthly data) when the S&P 500 was down -36%. Gold recovered to new highs in 2011 but since then it has seen drawdowns as large as -42% amid near zero inflation (in 2015) and a significant compression of nominal and real bond yields. The precious metal is yet to recover despite inflation rising above 2.5 percent. Nominal and real bond yields have spiked in 2018 but Gold is down more than -8% year-to-date (as of September 30th), confounding the inflation hedge story.
All this is to say that it is hard to understand why Gold moves the way it does. So when stocks or bonds zig, it is not a guaranteed that Gold will zag. However this is true even with other alternatives. Which brings forth an important point – that Cash may be as good a diversifier as any.
The one thing we can be certain of is that stocks and bonds will see significant drawdowns again at some point. So we close with five takeaways:
1. Using an overlay strategy with other alternatives like the one we outlined here offers an attractive ‘alternative’ to traditional 60/40. The advantage is that it does not compromise on the strategic beta an investor wants (like 60/40), and the alternative overlay just has to ‘beat’ cash. Though even this is not easy.
2. Buying insurance via puts, which is the closest to an actual hedge, comes at significant cost.
3. Rather than allocating to Managed Futures or Market Neutral strategies as an entire asset class, the better approach may be allocating to those managers who have shown skill in providing adequate diversification across various market environments. While also providing a higher return than Cash.
4. Gold works well as a diversifier, though as we discussed above, it is difficult to understand why exactly. Which makes it hard to hold on to during sustained periods of underperformance (not that it is easy to hold onto an underperforming asset even if you understand it well).
5. Cash may be the best diversifier even though it is typically viewed as something that has to be put to work immediately. Contrast that to Warren Buffet’s attitude towards cash, as Alice Schroeder, his biographer, describes:
He thinks of cash differently than conventional investors. This is one of the most important things I learned from him: the optionality of cash. He thinks of cash as a call option with no expiration date, an option on every asset class, with no strike price.
* Rebalanced monthly. US Treasuries proxied by the Bloomberg Barclays US Treasury Total Return Unhedged USD.
** Note that this is different from the CBOE S&P 500 5% Put Protection Index (PPUT).
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