“May you live in interesting times” is an oft-cited quote of supposed Chinese origin. While its origin is up for debate, few can question its relevance in the capital markets of the past two years. Correlations soaring, liquidity-based selling of unprecedented scale, three and four sigma returns across a host of unrelated assets, all seemed beyond the realm of possibility three years ago. Our theories of efficient markets and normal distributions indicated that these results were possible… but it could not plausibly happen to us. For all practical purposes, this past couple of years has seen the investment equivalent of “Land of the Lost,” the 1970s television show where the heroic “modern” family suddenly find themselves immersed in a world of creatures whose existence was thought impossible—dinosaurs, cavemen, and mythical beasts.
Following what we have termed the Take No Prisoners market of 2008 and early 2009, the Mother of all Recoveries market of 2009 continued in the third quarter. The seven-month rally from the lows at the end of February has been breathtaking. With a gain of 45.8%, it was the best seven months of performance for the S&P 500 Index since 1938. International stocks posted a seven month total return of 60.0%, the fourth best such period for the MSCI EAFE Index. But international stocks weren’t alone—it was the best seven month stretch ever for emerging markets stocks (+86.7% for the MSCI Emerging Markets Index), high-yield bonds (+45.1% for the BarCap US Corporate High Yield), and REITs (+75.1% for the FTSE NAREIT Index). Only long-term Treasuries, the lone double-digit winner of 2008, failed to make the black. Last Christmas, we suggested that 2009 would be an “ABT” (anything but Treasuries) year; we had no idea that this forecast would be so impressively true.
Amidst this remarkable environment, plan sponsors had impressive opportunities to either lock in losses or earn outsized returns. Naturally, most investors did the former, as the pain was too great, the uncertainty too unsettling, or the margin call too contractually binding! Only a few brave souls stepped up and embraced the forward-looking return opportunities embedded in wiped out asset classes—either through a simple rebalance to policy targets or, for the rare contrarians, a sizeable new commitment to risk assets—at the market troughs of November and March. Indeed, the average investor, given the tendency to sell out at the bottom, would have likely been better off sleeping through the entire meltdown and post-crisis rally. In this issue we examine what the “Rip Van Winkle” investment strategy of buying at the start of 2008 and holding through 2009 tells us about asset allocation, risk premiums, and diversification.
Financial Crisis and Post Rally Total Returns
What would total returns look like if we combined the crisis of 2008 and the first nine months of 2009? As Table 1 shows, only half of the asset classes were down on a cumulative return basis over this time period.
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.
As we have noted before, most investors have relatively poorly diversified portfolios. They rely too heavily on equity for their risk premiums, but there are other risk premiums out there! High-yield bonds, emerging market bonds, commodities, and even investment-grade credit all offer premiums for bearing risk that, at times, can be in the ballpark of equities. And they offer diversification! Yet most investors continue to rely on equities as the primary growth engine in their portfolios despite a risk premium that is far from reliable.
The 2008–09 experience was also a tutorial on compounding. Consider emerging markets equities, which returned (as measured by the MSCI Emerging Markets Index) –53.2% in 2008, but came roaring back with a nine-month return of +64.9% in 2009. Does this mean emerging markets equities have a net gain over the entire period? Of course not! A 50% loss translates to a required 100% gain on your remaining capital to “break even.” No wonder Charles Ellis recently wrote, “Large losses are forever—in investing, teenage driving, and infidelity. If you avoid large losses with a strong defense, the winnings will have every opportunity to take care of themselves.”3 In our minds, the easiest way to play defense is to diversify more broadly and, absent very compelling valuations, lessen one’s equity exposure. Note how an equally weighted portfolio in Table 1 would have incurred a very small loss, nearly 800 bps better than the traditional 60/40 portfolio.
The benefits of rebalancing within equities also proved of minimal value. Regardless of style or geography, traditional cap-weighted equity index returns were tightly clustered in the –20% to –30% range, as evidenced in Figure 2. Meanwhile, price indifferent approaches, whether it be a Fundamental Index™ approach like RAFI™ or equal weighting, fell in the –10% to –20% range. Why the discrepancy? Because they rebalance! As we have written before, rebalancing is a relatively inexpensive way of capturing added value.
These results support our view that it is time for investors to diversify their equity exposure by passive orientation in addition to by style and geography. Indeed, simply blending index approaches in the United States would have provided more diversification over the past 21 months than by blending five different cap-weighted style and geographic mandates. Is this certain to repeat? Of course not. But it does illustrate that this kind of passive diversification be addressed, perhaps on the same priority level as other equity structure discussions.
As investors look back on this remarkable period in the capital markets, they may be tempted to break the combined period into two distinct periods—the Take No Prisoners market of 2008 and the Mother of All Recoveries in 2009. We feel that would be a mistake. Short-term, temporary dislocations shouldn’t drive long-term portfolio decision making. Yet how many portfolio decisions were made in the fall of 2008 or early 2009? And how many of these decisions added value over and above a “Don’t just do something, stand there!” strategy? A scant few.
Most investment committees would have been better off, like Rip, sleeping through the past 21 months of tumultuous activity. Of course, an even better course of action would have been to embrace risk—in distressed asset classes and sectors within equities—during the dark days. Admittedly, such a step up is near impossible given the human tendency to shy from pain unless, of course, it was previously embedded in a portfolio through a disciplined global tactical asset allocation process or an automatically contratrading Fundamental Index approach.
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1. The equally–weighted portfolio comprises the following 16 indexes, rebalanced monthly. ML US Corporate & Government 1-3 Year; LB US Aggregate Bond TR; LB US Treasury Long TR; LB US Long Credit TR; LB US Corporate High Yield TR; Credit Suisse Leveraged Loan; JPM EMBI + Composite TR; JPM ELMI + Composite; ML Convertible Bonds All Qualities; LB Global Inflation Linked US TIPS TR; FTSE NAREIT All REITs TR; DJ AIG Commodity TR; S&P 500 TR; MSCI Emerging Markets TR; MSCI EAFE TR; Russell 2000 TR.
2. In Figure 1, we utilize the Ibbotson Long Term Government Bond series as the 40% bond allocation instead of the BarCap Aggregate due to the longer history of the Ibbotson series (1926) versus the BarCap (1976).
3. Charles Ellis. 2005. “Investing Success in Two Easy Lessons.” Bold Thinking on Investment Management: The FAJ 60th Anniversary Anthology (September):114–116.