“Diversification will always disappoint” is an old adage in the finance industry. It encompasses the feelings that we all get when we near the end of a month, quarter, or year and see that some investments did better than others. In hindsight, investors can always look back and think, “It was obvious markets would be smooth, and I should only have invested in US stocks,” or, “I should have known that a virus was going to have a dramatic impact on the global economy, and I should have held more bonds just for the first quarter of Q1 2020.” But in reality, nobody knows what direction the market is going to head over the next three days or three months. Markets are not perfectly efficient, but they do an excellent job rapidly pricing in news and expectations.
Events over a short period that move the market up or down by 10% are by definition unknowable–otherwise every investor would have already adjusted and moved out of those positions destined to fall. Before stocks fell by 2.5% and oil by 12% on Nov 26 on news of a new COVID variant, we all knew there was some non-zero chance of new variants arriving, but that didn’t stop the market from rising over the last twelve months. The sudden adjustment was a pricing in that there is now a known new variant, and it could be more contagious than previous versions of the COVID-19 virus. As information emerged that the new variant may be less dangerous, markets resumed their rally into the end of the year.
That’s not to say some investors will not do better than the market over any given period. Perhaps they have an outlook that differed from the overall market and were correct in that instance. But over time, consistently outperforming the market has shown to be difficult, if not impossible for money managers around the globe.
With 2021 now behind us, we can start to look back and see that many areas of the market performed very well with relatively low levels of volatility, such as US large cap growth stocks or Canadian energy companies. Other areas did well compared to normal annual growth rates, such as US small companies or international developed companies, but underperformed the star US or Canadian counterparts. And then some areas were fairly flat: alternatives that have downside protection or market neutral target exposures, gold being slightly down despite the highest inflation of the last 30 years, emerging markets struggling as China adjusts the business operating environment, fixed income being flat to negative with bond markets seeing slight decreases in value as interest rates ticked up and swallowed partly starting yields. Following a significant run up in stock markets from April 2020 to the start of 2021, any rebalancing that was done was prudent from a risk management standpoint but punitive from a total return standpoint when stocks continued to outpace bonds throughout the year. We will discuss individual positions which were above, in line, or below expectations in a second part of this paper coming shortly.
It’s natural to look back and wonder if a small allocation to emerging markets is useful when the area trailed the S&P 500 by 30% over the last 12 months. But we must also look back at previous times like in 2006 when it led by 20%. Or with gold, which trailed broad Canadian stocks by over 30% the last 12 months yet outperformed by 40% during the five weeks of the initial COVID impact on markets in 2020. Likewise, tilts towards smaller, more innovative companies, which trailed large cap stocks in 2021 by a whopping 40% but had outperformed in 2020 by an even greater 50%.
All of these pieces will have years in which investors are thankful for them, and others where they are cursed. Part of setting up a long-term financial plan and goals is determining what type of an asset mix can best help you accomplish those aims. By having exposures to a variety of areas in terms of geographies and strategies, it’s absolutely a guarantee that you will underperform the best asset class each year, whatever that may be, US growth stocks or Canadian financials for example. But there will be other years when those particular areas see significant corrections and having those other elements of diversification is what can keep a portfolio on track for its long-term goals.
Looking at the attached data from JP Morgan’s most recent Guide to the Markets, they show a variety of asset classes’ performance over the previous 15 years. What sticks out most is just how random the year-to-year returns seem to be. This chart is often referred to as a ‘Skittles’ chart because it looks almost as if you took a bag of Skittles and dumped it on a table. You wouldn’t expect all the red or yellow to land near each other. Areas like Commodities or REITs which were the worst performers in 2020, came out on top in 2021.
Over this timeframe you can see that US stocks have done very well, averaging nearly 10% per year in returns, while cash and bonds have been in the low single digits. Yet in years like 2008, allocations to those lower volatility portions of the portfolio paid significant dividends. The diversified portfolio they show is a combination of roughly 55% in global stocks, 35% in bonds, and 10% in alternatives, and is gross of any fund implementation or advisory fees. While the annualized return comes in below US stocks and REITs, the volatility during the same timeframe is only about half—meaning the highs and lows were muted and a portfolio was able to continue growing for a larger portion of the time.
Going forward into 2022
We were recently included in a Bloomberg article about how family members would discuss some of the successes of 2021 around the Thanksgiving table. We mentioned, “Let’s all be thankful for the tremendous returns we’ve seen in tech stocks and numerous other areas of the market this year, but not forget that a slice of humble pie may be what we’re eating next year if we’re too certain of our predictions to come.” Without trying to predict how market performance will play out, are there things that we can look at when making any adjustments to portfolios in the near term?
A few things stick out when you simply take a look at valuations around stock and bond markets. The first being that international stocks are trading at dramatically lower multiples in terms of price to earnings than their US counterparts. Does it make sense that two companies should trade at dramatically different ratios simply because they are domiciled in different countries? Take Hersey and Nestle for example. Both sell a lot of chocolate in North America. Both likely have relatively similar input costs in terms of cocoa and labor. There may be some small tax differences, but should they trade at a significantly different price-to-earnings ratio just because of their country of domicile? The chart to the right shows that International stocks are currently trading at a very large discount to US stocks in terms of their relative price to earnings ratios.
The next chart shows the periods of time when US stock markets have outperformed international markets or vice versa. The US market has been outperforming for more than the last decade, and there is no set rule that says that cannot continue for longer into the future. But if we look back over time, it seems reasonable to expect that different areas of global stocks would lead performance during different periods, as we’ve seen in the many decades prior to this.
International: Price-to-earnings discount vs. U.S.
MSCI AC World ex-U.S. vs. S&P 500 Indices, next 12 months
Source: FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management,Guide to the Markets – U.S. Data are as of December 31, 2021
MSCI EAFE and MSCI USA relative performance
U.S. dollar, total return, cumulative outperformance*
Source: FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management. *Cycles of outperformance include a qualitative component to determine turning points in leadership. Guide to the Markets – U.S. Data are as of December 31, 2021
There is nothing to say that those deviations can’t continue, or even grow further apart, but when we take a long-term perspective on investing, the evidence would suggest that yesterday’s winners will not always be tomorrow’s winners. Knowing when that winning streak will end is also challenging. And thus, another rationale for maintaining a diversified approach over time.
What can we be doing now?
On the conservative side of portfolios, we’ve long discussed the fixed income piece as a volatility dampener and a shelter for when stocks get rocky, looking to limit the downside of stock market corrections which can be severe and (in downturns other than 2020) can often take years to get back to positive territory. However, gone are the days when investors could allocate dollars towards government bonds or high credit quality securities and easily earn 5% a year or more with a lot of negative correlation. We’ve made changes to our fixed income exposure over the years to slightly reduce the amount of interest rate sensitivity of the bonds held. We’ve also added elements and dynamic exposures in 2021 which were able to avoid some of the worst of the bond market declines—the Canadian government bond market being down 3% for example.
That role of bonds acting as a volatility dampener historically has worked extremely well. Investors were able to receive a reasonable ongoing yield while having an asset that likely rose in value if the economy/stocks hit a rough patch and central banks looked to cut interest rates. In today’s environment with the ongoing yield very low, and some risk that in future declines bond yields may not have as much room to move downwards, that relationship doesn’t seem as sure as it did over the last few decades. Additionally, we want to ensure that over time we are balancing all of the risks to a portfolio. Short term volatility is certainly a consideration but so too is the inability to keep growing portfolios in real terms with growth rates above the level of inflation. Currently that is much more challenging for portfolios with very high levels of fixed income allocations.
As an Investment Committee, we held over a dozen manager due diligence meetings in 2021 hearing about potential bond strategies from some managers we are utilizing and others we are not. We have made some adjustments in 2021, going into 2022, will continue to review the area for any adjustments which may be able to better service that role of lowering portfolio level volatility.
One area we look to continue developing to help make portfolios more robust to a variety of market environments is the alternatives and real assets area. One of the additional benefits of the partnership with Focus Financial earlier this year was to gain access and economies of scale to some strategies which we could not before, by working together with some of the other partner firms. There is no requirement or incentive for us to do so. It would simply be if those solutions could further help your particular situation and made sense for your investment policy statement. Having a bigger toolkit available is helpful, especially as the historical stock/bond relationship may face some turbulence.
The area is not without risk. Instruments may be harder to value or holdings like commodities can have their own significant volatility. Losses can occur in this area from different factors than those which impact stocks or bonds. But by looking to combine some asset classes which do not perform in the same manner as stocks and bonds, we look to continue to make the portfolios more robust to a variety of different investment regimes. Going forward we will be breaking out that small segment from the overall stock and bond allocations so that there is better transparency to each segment of portfolios.
One way to visualize the three main components of your portfolio (stocks, bonds, and alternatives) is with a football analogy in which we view them as offense, defense, and special teams respectively. The stock portion is meant to create the meaningful growth in real wealth over time, with the opportunity to put the portfolio value ahead of schedule, though it’s not going to be successful every time. The bonds portion would be in the position of trying to limit the downside. By seeing smaller losses in downturns, a portfolio can start to grow sooner after those corrections and better be able to maintain withdraws over the long term. Alternatives enter into the equation as special teams—unique strategies to try and accomplish specific goals. Some holdings may be specifically targeting the risks of higher-than-expected inflation levels, while others may be aiming to generate returns in a manner that doesn’t look like the return we see from stocks or bonds, say by following certain systematic trends or having a market neutral exposure. Just as in a football game, the place kicker plays a much different role than a quarterback or linebacker. By combining these, we are aiming to create a more dynamic and complete team that can see success in a variety of different scenarios.
Diversification will never be an exciting way to invest. Yet, without a crystal ball about what short-term market returns will look like, it gives us the best odds of meeting the long-term goals and objectives for the assets. We look to continue to make small adjustments along the way to balance the different risks facing portfolios—such as inflation, low bond yields, or high equity valuations—but realize there is no silver bullet to generating higher returns. Focusing on a long-term financial plan utilizing reasonable assumed growth rates, executing a tax efficient investment implementation, and keeping a long-term perspective are our best tools as investors.
Sources: U.S. Department of the Treasury, Morningstar Direct 2022, JP Morgan Guide to the Markets Dec 31, 2021.
Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Emerging markets involve additional risks, including, but not limited to, currency fluctuation, political instability, foreign taxes, and different methods of accounting and financial reporting. All investments involve risk, including the loss of principal and cannot be guaranteed against loss by a bank, custodian, or any other financial institution.