I have taught at the NYU Stern Graduate School of Business for many years. Each semester, I give students a quiz to see how they define risk. Academics define risk as the volatility or unpredictability of returns. However, students consistently define risk not as volatility, but rather as the probability of losing money. I’ve done many similar surveys with all types of audiences, and every audience defines risk as the probability of losing money (or as the probability of falling below some required rate of return). Never has a group I’ve surveyed defined risk as volatility.
Supporting these less-than-scientific results, there have been numerous academic studies that suggest investors’ reactions to market risk are not symmetric. Investors consistently react more negatively to losses than they do positively to gains.
At the beginning of a typical market cycle, investors are more fearful of losses than normal. In the midcycle, they tend to be more accepting of risk and appear to have more normal risk. In the late cycle, investors generally embrace risk and attempt to accentuate returns because they believe there is no downside risk.
Data clearly show that no group of investors is currently willing to take excessive U.S. equity risk. Pension funds, endowments, foundations, hedge funds, individuals, Wall Street strategists and even corporations themselves remain more fearful of downside risk than they are willing to accentuate upside potential.
One might argue that the valuations of stocks like social media, biotechnology and small energy argue that there is a “bubble” forming in stocks. These areas of the stock market do, indeed, seem excessively speculative, but the enthusiasm for these groups has not translated into enthusiasm for U.S. stocks as a whole. As we have previously pointed out, high-beta1 stocks within the S&P 500 are near historically low relative valuations.
The probability of a bear market still seems low to us. Bear markets are made of tight liquidity, significantly deteriorating fundamentals and investor euphoria. Although the Fed is starting to reverse course, there are no signs yet of a significant tightening of liquidity. Rather, the data are beginning to suggest that private sector credit growth is starting to replace the Fed as the provider of liquidity. Corporate fundamentals continue to be healthy, and investment, whether in inventories or capital equipment, has yet to show any sign of extreme. As mentioned, we can find no group of investors who are shunning diversification or leveraging upside participation in U.S. equities as an asset class.
Regardless of these healthy signs, most investors continue to focus on protecting the downside. However, investors don’t seem to have learned the lesson of the past cycle. Investors continue to confuse the number of asset classes with diversification. Diversification isn’t based on the number of asset classes, it’s based on the correlation of returns among the asset classes.
One central tenet of our portfolios remains that there are very few asset classes that truly “protect against the downside risk in equities.”
Upside/downside capture is a simple measure that shows how an investment relates to the movements of the stock market. Returns are separated into two groups: those when the stock market rises and those when the stock market falls. The capture shows the proportion between the asset’s returns and the overall stock market’s return. For example, if the average up return for the S&P 500 was 10% and the average up return for a particular asset was 7.5%, then the upside capture ratio would be 75% (7.5/10). Similarly, if the average down return for the S&P 500 was -10% and the average down return for the asset was -12%, then the downside capture ratio would be 120% (-12/-10). The goal is to find assets that have a high upside capture, but a low or negative downside capture.
Exhibit 1 shows a scatter of upside/downside capture ratios for a broad set of asset classes based on returns during the past 10 years. The quadrants depict the four possible combinations, i.e., lower upside/lower downside, lower upside/higher downside, higher upside/higher downside and higher upside/lower downside. The 45-degree line shows equal upside/downside ratios.
There are several points that investors should consider when reviewing this chart:
- Very few asset classes have exhibited true downside protection. Note that most asset classes fall close to the 45-degree line, which suggests that most asset classes participated equally in bull and bear markets.
- Only one asset class, long-term Treasurys had negative correlation to stocks, i.e., negative upside and downside capture ratios. Treasurys, and other fixed-income categories like high-grade corporates and higher-quality municipal bonds, should probably be part of any all asset strategy designed to truly protect against downside risk.
- Although we don’t find gold attractive within the current market environment, gold was a reasonable diversifier over the past 10 years. However, it hasn’t offered as much downside protection as it did upside participation. By contrast, commodities do not seem to offer an attractive upside/downside.
- Hedge funds are not a panacea. Note that hedge funds have historically offered about 70% of both the upside AND the downside. There seem to have been many asset classes that offered similar captures with considerably lower fee structures. For example, an indexed combination of riskier fixed-income (emerging-market sovereign debt and high-yield corporates) had a superior upside/downside capture ratio to hedge funds.
- Cash is generally a worthwhile diversifier. It exhibited minimal upside, but slightly negative downside.
Asset allocation requires swimming against the tide
Investors, regardless of whether they are institutional or individual, tend to follow trends when determining asset allocation decisions. Yet, history has shown that swimming against the tide and investing in unpopular asset classes has been the route to true diversification and investment success.
Our core investment philosophy has always been that uncertainty equals opportunity. The data suggest that we continue to differ with the consensus regarding our bullish views toward the U.S. market, and regarding our views with respect to which asset classes offer diversification and downside protection.
1Beta is a measure of risk which shows a fund’s volatility relative to that fund’s stated benchmark. A fund with a beta of 1 performed exactly like the market index; a beta less than 1 means its performance was less volatile than the index, positive or negative.
The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions available from the sponsors or originators of the respective indexes. Anyone interested in such further details is free to consult each such sponsor’s or originator’s website.
The past performance of an index is not a guarantee of future results.
Each index reflects an unmanaged universe of securities without any deduction for advisory fees or other expenses that would reduce actual returns, as well as the reinvestment of all income and dividends. An actual investment in the securities included in the index would require an investor to incur transaction costs, which would lower the performance results. Indexes are not actively managed and investors cannot invest directly in the indexes.
S&P 500: Standard & Poor’s (S&P) 500 Index. The S&P 500 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad U.S. economy through changes in the aggregate market value of 500 stocks representing all major industries.
U.S. Mid Cap: Standard & Poor's MidCap 400 Index: The S&P MidCap 400 Index is an unmanaged, capitalization-weighted index designed to measure the performance of the midsized companies of the U.S. stock market.
Russell 2000: Russell 2000 Index. The Russell 2000 Index is an unmanaged, market-capitalization-weighted index designed to measure the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index.
MSCI ACWI: MSCI All Country World Index (ACWI). The MSCI ACWI is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of global developed and emerging markets.
EM: MSCI Emerging Markets (EM) Index. The MSCI EM Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of emerging markets.
Frontier: MSCI Frontier Index. The MSCI Frontier Index is a free-float-adjusted, market-capitalization-weighted index designed to measure the equity-market performance of Frontier markets.
Gold: Gold Spot USD/oz Bloomberg GOLDS Commodity. The Gold Spot price is quoted as U.S. Dollars per Troy Ounce.
Commodities: S&P GSCI Index. The S&P GSCI seeks to provide investors with a reliable and publicly available benchmark for investment performance in the commodity markets, and is designed to be a “tradable” index. The index is calculated primarily on a world production-weighted basis and is comprised of the principal physical commodities that are the subject of active, liquid futures markets.
REITS: The FTSE NAREIT Composite Index. The FTSE NAREIT Composite Index is a free-float-adjusted, market-capitalization-weighted index that includes all tax qualified REITs listed in the NYSE, AMEX, and NASDAQ National Market.
3-Mo. T-Bills: BofA Merrill Lynch 3-Month U.S. Treasury Bill Index. The BofA Merrill Lynch 3-Month U.S. Treasury Bill Index is comprised of a single issue purchased at the beginning of the month and held for a full month. The Index is rebalanced monthly and the issue selected is the outstanding Treasury Bill that matures closest to, but not beyond, three months from the rebalancing date.
Equity investing is subject to stock market volatility. Smaller companies are generally subject to greater price fluctuations, limited liquidity, higher transaction costs and higher investment risk than larger, established companies. Investments in foreign instruments or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical or other conditions. In emerging or frontier countries, these risks may be more significant. Smaller companies are generally subject to greater price fluctuations, limited liquidity, higher transaction costs and higher investment risk than larger, established companies. Investing involves risks including possible loss of principal.
Investing is an inherently risky activity, and investors must always be prepared to potentially lose some or all of an investment’s value. Past performance is, of course, no guarantee of future results.
©2014 Richard Bernstein Advisors LLC. All rights reserved.
Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent the past or future performance of any fund.
The following information was prepared by and has been reprinted with the permission of Richard Bernstein Advisors LLC. The views expressed herein are those of Richard Bernstein Advisors LLC. Information provided and views expressed are current only through the month stated on top of each page (May 2014). The opinions herein are not necessarily those of the Eaton Vance organization and may change at any time without notice. The information contained herein has been provided for informational and illustrative purposes only and is not intended to be, nor should it be considered, investment advice or a recommendation to buy or sell any particular security. Investors should consult an investment professional prior to making any investment decision. While information is believed to be reliable, no assurance is being provided as to its accuracy or completeness.
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Richard Bernstein is CEO & CIO of Richard Bernstein Advisors LLC, which serves as a subadvisor to two Eaton Vance mutual funds.