- January 2016 was a painful start to the year for equity investors
- The stock market turmoil has been reminiscent of the August 2015 crisis
- It has taught a lesson about the importance of diversification with bonds
- A balanced portfolio has a 20% better Sharpe ratio than an all-equity portfolio
- Not only bunds but even EM bonds outperformed equities in January
- Diversification functions like an airbag in a car when markets crash
"Sir, would you like airbags in your car, or do you prefer to fly
through the windscreen?" Photo: iStock
By Simon Fasdal
The year has got off to a surprisingly weak start for long-only investors. January, which usually has a good track record, saw terrifying performance in most equity indices. At its worst, the turbulence hit with with same horror as the August 2015 selloff, not unlike the fear depicted in Edvard Munch's The Scream.
Edvard Munch, The Scream (woodcut, 1895, public domain image).
As a seasoned equity investor, you know how to diversify your equity portfolio. You have a sector and country split, and your value-hunting approach has performed well in the last few years. Despite an overall diversified approach, however, almost all indices were beaten, so unless you were lucky to stick to Mexico, Indonesia and Thailand, my best guess is your equity portfolio hit the storm head on and crashed with a drop of 10%.
There are ways to avoid this one-sided risk approach, which indeed is one-sided no matter how many sectors you have added to your equity portfolio.
"Bonds?," you say, "you must be out of your mind. Whatever you're selling I'm not buying any bonds at these record low yields."
Dax index vs 10-year bund price
Source: Bloomberg, Saxo Bank
But take a look at the recent correlation between Germany's Dax index and bunds: despite record-low yields, the knee-jerk reaction to the selloff in equities still led to a spike in bunds. Back in 2014 I started to doubt this classic correlation pattern, due to the overall lower-yield environment. And we have indeed seen "fallouts" like the August 2015 selloff, where all asset classes were sold off, offsetting low or negative correlation between bonds, equities, commodities and credit. In my view, this was mainly due to implosion of risk parity funds, rather than an end to the classic correlation patterns.
No need to say that the classic portfolio approach shows how a risk-adjusted return (Sharpe ratio) is higher on a balanced portfolio than an all-out equity approach. Long-term unadjusted performance might be better with pure equities, but a balanced portfolio has a 20% better Sharpe ratio than an equity-only portfolio.
And also in a more practical and very relevant way, the initial positive effect of negative correlation between equities and core bonds has not only made German bunds a star performer. The global decline in yields has helped performance in most bond classes, despite global equity selloffs. The below chart is an eye-opener, which shows that even emerging markets bonds outperformed equities in the January turbulence.
Source: Bloomberg, Saxo Bank
Timing is essential, but please consider adding elements of fixed income to your equity portfolio, as January 2016 demonstrated exactly how effectively bond-equity diversification works like an airbag when markets hit a wall.
Why not take precautions for when stock markets hit a wall? Photo: iStock
– Edited by John Acher