This period was a true bear market (down more than 20%) only for capitalization-weighted equity indexes, commodities, and REITs (which trade on the same exchanges as stocks). Fixed-income categories, even those with substantial credit exposure, posted reasonable gains. Indeed, long Treasuries led the way with a 14.1% gain, with long investment-grade credit (+13.1%) and emerging market bonds (+12.2%) also well in the black. Likewise, high-yield produced a double digit positive return with a cumulative gain of 10%.
Of course, these figures hide much of the sizeable short-term stress from deleveraging. Convertibles were at one point down more in the bear market than equities. High-yield was down 26% in 2008, its worst year ever! Emerging market bonds fell 19% in September and October of 2008 alone. But each of these has survived the severe dislocations and, on the heels of the 2009 comeback, produced positive returns over the entire span. Meanwhile, despite historic rallies over the past seven months, equities still remain well under water. This is particularly true of cap-weighted indexes where price weighting ensured that the once-beaten down leaders, which have led the comeback rally, had minimum exposure just before the recovery. Within equities, the bear could have been avoided by simply using a better indexing approach as evidenced by the FTSE RAFI 1000 Index loss of “only” 15.8%!
Equally weighting 16 of these asset classes, as we have done in previous issues of Fundamentals, leaves an investor down about 3.4%.1 True diversification—well beyond the conventional 60/40 illusion of diversification—has served us very well again.
What Did We Learn?
We assert this combined 2008–09 return analysis has several key takeaways for long-term investors. While these conclusions are drawn over an admittedly short horizon (it sure felt far longer than 21 months!), we are confident that these themes have merit for those with 10-year, 15-year, and even perpetual time horizons.
First, equity risk dominated once again. Look at the performance of the traditional 60/40 mix in Table 1. Downside equity volatility swamped the 40% allocation to bonds. The BarCap Aggregate went up, but not enough. The dominance of equity risk is a persistent pattern, as shown in Figure 1.2 Note how the 60/40 portfolio, on average, captures 60% of the equity downside, which brings us to the follow on point.