By LARRY SWEDROE
This year’s significant declines in both stocks and bonds dealt a large blow to traditional 60/40 portfolios that relied on the hedging properties of bonds to protect against sharp drops in equity prices. As of the close on May 9, 2022, Vanguard’s Total Stock Market Fund (VTSMX) had lost 17.5%, and their Total Bond Market Fund (VBTLX) had lost 10.4%. Even the safest bonds, U.S. Treasuries, had fallen sharply — for example, Vanguard’s Long-Term Treasury Fund (VUSTX) lost 21.4%. And international equities did not provide much of a diversification benefit, with Vanguard’s Developed Markets Index Fund (VTMGX) losing 16.6% and their Emerging Markets Index Fund (VEIEX) losing 16.8%.
Correlations are time varying
Over the long term, the correlation of the S&P 500 Index to long-term (20-year) Treasuries has been close to zero—over the period 1927-2021, the monthly correlation was just 0.063.
However, as Lieven Baele and Frederiek Van Holle, authors of the 2017 study Stock-Bond Correlations, Macroeconomic Regimes and Monetary Policy, noted: “There have been persistent episodes of large negative stock-bond correlations, in particular since the end of the 1990s. For example, the U.S. stock-bond correlations were about 20% during the 1970s, increased to, on average, 40% during the 1980s and the first half of the 1990s, to drop to, on average, minus 20% since 1998. Correlations varied substantially though over these sub periods: Correlations were as high as +70% in the fall of 1994 and as low as -67% in Q2-2003 and Q3-2012.
Stock and bond correlations are time varying
The time-varying nature of stock-bond correlations means that safe Treasuries do not always provide the portfolio ballast investors rely on. While negative stock-bond return correlations tend to occur during flight-to-safety (FTS) episodes, during which increased stock market uncertainty induces investors to flee stocks in favor of bonds, positive correlations tend to occur during periods of stagflation (rising inflation and weakening economic growth). With slowing economic growth, risk aversion pushes up the equity risk premium and rising inflation causes bond yields to rise, leading rising correlations to emerge at exactly the wrong time. This is what happened during the first part of 2022, causing distress for traditional 60/40 portfolios.
Investor takeaways
Empirical research findings show that investors need to understand that stock-bond correlations are time varying and regime dependent—negative stock-bond correlations are associated with periods of accommodating monetary policy in combination with low to intermediate inflation; however, correlations are positive in the high inflation regime, irrespective of monetary policy stance.
The risk that both stocks and high-quality bonds can perform poorly at the same time is why an investor should consider an allocation to investments that have low to no correlation to both stocks and bonds. These are among the assets investors could consider:
Reinsurance (which has no correlation to the economic cycle risk of stocks or the inflation risk of bonds), accessed via such funds as Stone Ridge’s SRRIX and SHRIX, and Amundi Pioneer’s XILSX.
Long-short factor funds, such as AQR’s QSPRX and QRPRX.
Private credit funds, such as Cliffwater’s CCLFX (which makes senior secured loans to middle market companies with an average loan-to-value ratio of only about 50%) and CELFX (in addition to middle market lending, it also invests in assets that have little to no exposure to economic cycle risk such as drug royalties, litigation finance, and life and structured settlements), which invest in floating rate loans (eliminating duration/inflation risk); and Stone Ridge’s LENDX, which invests in fixed rate but shorter term (expected duration of about one year), fully amortising prime (not junk) consumer, small business and student loans (minimising inflation risk while accepting economic cycle risks, though those risks have been well below that of stocks).
Demonstrating a recent example of not being correlated with stocks and bonds, through May 9, 2022, while both stocks and traditional bonds performed poorly, each of those funds provided positive returns. Of course, this will not always be the case, as they do have their own unique set of risks and there will be occurrences where this will occur. However, their low correlation, unique risks and related risk premiums provide investors a way to increase diversification, creating a more efficient portfolio by reducing the tail risk of the traditional stock and bond portfolio.
The empirical evidence (for example, as presented regularly in the SPIVA Active versus Passive Scorecards) demonstrates that while the stock and bond markets are not perfectly efficient, they are highly efficient. If markets are highly efficient, then investors should expect all risk assets to have similar risk-adjusted returns (if that was not the case, funds would flow into the higher risk-adjusted returning asset until an equilibrium was reached). And if all risk assets have similar risk-adjusted returns, then investors should consider diversifying across as many unique sources of risk as they can identify that meet their criteria of earning a risk premium that has been persistent across time and economic regimes, pervasive around the globe, robust to various definitions, survives transactions costs and has intuitive risk or behavioral explanations for why the premiums will persist. Each of the aforementioned funds meets those criteria, which is why investors should consider including allocations to them, creating a “risk parity” type of portfolio instead of the concentrated risk of the traditional stock and bond portfolio. For those interested in learning more about the benefits of such strategies, I recommend reading the 2018 edition of Reducing the Risk of Black Swans.
Picture: Paul Teysen via Unsplash
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