Monday, March 14, 2022

Diversification Doesn't Always Feel Good

Cullen Roche rhetorically asked if 60/40 is finally dead. He was of course referring to the standard allocation of 60% into equities and 40% into bonds. He notes that bonds haven't really come through this year to offer ballast to the equity market declines. 

I've been writing about the flaws, as I see them, with 60/40 for many years. Yields have been low and going lower for many years until recently. The ten year US Treasury is currently in the neighborhood of a 2% yield which is higher than it's been for awhile but I would argue that even 3% for ten years is not very attractive. Of course if/as yields go up, the price of bonds and bond funds will go down. That is the risk when you buy fixed income at a high price (low yield). With a bond you will eventually get your money back, save for a default, but with bond funds there is no par value for the fund to return to. 

The relatively low yields more than 15 years ago pushed me to learn about alternatives, back then there's wasn't really a term for them so I called them diversifiers, that would help manage the volatility of a normal equity portfolio. Back then it was pretty much just gold, inverse index funds and a managed futures mutual fund. All three do a great job, IMO, of maintaining their low to negative correlation to equities so they do tend to go up when equities go down but they also go down when equities go up and equities go up the vast majority of the time. I don't want a portfolio of alternatives that are hedged by a little equity exposure. Equities go up most of the time, so I want to maintain an equity portfolio and am reasonably confident that the alternatives I use will do what they're supposed to in terms of hedging, more often than not. 



The chart shows most of the alternatives I use personally and for clients. I have been writing about all them for many years. BLNDX as possibly the newest addition is one I've used and written about for two years already. They are all up by varying amounts which helps. Early-ish last year I added a metals and mining ETF which has benefitted from the surge in reported price inflation. Of course we still have exposure to tech and discretionary and those are both struggling, doing worse than the S&P 500. 

It is crucial to understand that those things on the chart would probably all be underperforming the stock market if we were having another up year. BLNDX has at times kept up with equities and there was a stretch a couple of years ago or so where BTAL also kept up but that is not the expectation for either one. 

A good way to think about diversification is to ask yourself, if everything you own goes up together in a bull market, what is likely to happen when there is a bear market? They're likely to all go down together. You've diversified issuer risk but not market risk. My objective, as I have always articulated it, is to try to avoid the full brunt of large declines not to miss those large declines entirely. 

For now, the S&P 500 isn't really down a lot, it's only down a little. I am concerned that this could turn into down a lot so this morning I added to clients' existing position in SH increasing our hedge. The catalyst was not the death cross that looks like happened today but that the 200 day moving average is about to turn lower any day...maybe that happened today too. I took all previous action in regards to hedging with diversifiers long before the SPX breached its 200 DMA because certain risks seemed very high to me, risks having nothing to do with Russia invading Ukraine, that was not on my dance card early. 

One behavioral issue with these types of funds is that on the way up, you own too much and on the way down you don't own enough. On thing though is that if equities really puke down, I think at least a couple of the above mentioned funds could go up a lot. At some point, hedges need to come off, you don't need to protect against a large decline after a large decline, and those proceeds can either buy back in or be used to meet client income needs. If the market rockets higher starting tomorrow, then yes we will lag a little but not miss it--see own too much up above.  

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