How Will Your Portfolio Respond During Times of Market Stress?
Modern Portfolio Theory tells us that holding a well-diversified 'basket' of investments can be one of the best ways for individual investors to reduce risk to achieve a given level of performance. But a portfolio comprised of only stocks, bonds and real estate may not be enough to provide true diversification.
A Non-Correlated Portfolio: The Key to True Diversification
The key to Modern Portfolio Theory was the revelation that the risk of any investment can be reduced and/or performance increased by forming a portfolio of diverse and non-correlated assets. Simply put, a truly diversified portfolio contains not only a range of different asset types, but also assets that have low correlations to one another. Constructing your portfolio this way will reduce the likelihood that your assets will move in tandem, which can be especially important when the broader markets may be down and diversification may be most needed.
Diversity is a pretty general concept meaning simply a lack of similarity. When we want to speak technically with more precise language we use the statistical terms correlation and dependence, which describe and measure similarity. Correlation describes how pairs of securities act in relationship to each other over some period of time; if you can predict the change in one based on the change in the other, you have demonstrated inter-dependence. As investors, we know that owning a portfolio of highly correlated assets does little to cushion the impact of down markets, and we are told by our investment advisors that owning non-correlated or negatively correlated assets will protect us from market crashes and dampen our losses in bear markets. In short, you want something that will zig when the rest of the assets zag!
The Items in Your Basket
Think about non-correlation this way: You get up on a bright sunny day and decide to go to the farmer’s market quite a distance away. Once there you fill your basket with apples, oranges, bananas, lettuce, and on the way out you decide to add some eggs.
Market Volatility and Uncertainty
On your way home from the market your car overheats and breaks down. Let’s call this macro-economic stress, kinda like the near global meltdown in 2008! You’re quite a distance from home, with no cell signal, and the sun is blazing hot! (Market Stress!) You take your basket out of the car because of the furnace-like temperature inside. As you sit on the side of the road contemplating a resolution the temperature rises well above 100 degrees (Extreme Market Stress!), and you notice that it’s having quite an adverse effect on the items in your basket.
In the extreme heat your lettuce (Bonds) are the first to go. Your apples (Stocks) get brown and soft, and look totally unappetizing. Your bananas (Mutual Funds) begin to turn dark brown and mushy. Your oranges (ETF’s), because they are thick-skinned, go bad at a slower rate. But, go bad they do as well! And then you notice your eggs.
Because your produce items are all “of the earth” they are, in a manner, correlated. But, your eggs are of a slightly different ilk. Extreme heat actually cooks an egg. While in this scenario it might not make the tastiest, most appetizing morsel, it would certainly sustain. And more importantly, the extreme “market stress” not only didn’t render it useless, but rather, made it somewhat useful! The non-correlated nature of the eggs versus the produce proved beneficial in the event of the severe stress.
Commodity returns are expected to show small or even negative correlation with the returns of assets that belong to traditional asset classes like stocks, bonds and mutual funds. This is because the value of commodities is driven by factors such as weather and geopolitical conditions, supply constraints in the physical production, and event risk that are distinct from those that determine the value of stocks and bonds.
Commodities seem attractive because, after all, they are real assets, whose values are determined by immediate supply and demand factors. They are not financial assets, whose values depend on some contingent estimate of long-term earnings. With financial assets, market randomness is traditionally managed by mean-variance models (stemming from the work of Nobel Laureate Harry Markowitz) that result in an efficient frontier allocation of stocks and bonds to achieve the highest expected return per unit of risk (or standard deviation).
An Advantageous Twist
Another facet of commodity non-correlation that is often overlooked and/or misunderstood is the directionless trading/profit possibilities. Commodity futures and options trading allow for long or short positioning with a greater degree of ease than most other asset classes listed. The ability to profit in any market environment without regard to its direction is a priceless advantage over buying stocks, bonds or mutual funds. Commodities afford an investor the opportunity to trade without regard to a particular company's competitive position or future earnings prospects. That's, more often than not, a simpler forecasting proposition. Investors should be willing to sacrifice some of the upside potential of a pure equity/bond portfolio in order to preserve capital in times of a declining stock or bond market.
The Bottom Line
Constructing a portfolio capable of weathering all types of macro economic and political conditions is the key to successful trading. Properly diversifying a portfolio will reduce the amount of risk an investor is exposed to and allow for less volatile returns. Due to the prospective ability to capitalize on both up and down price movements in the futures market, the trading arena seems like a likely vehicle to produce results that are not necessarily correlated to more traditional holdings such as stocks, bonds, mutual funds and real estate.
-- Jeff Anthony, Managed Futures Specialist, Park Avenue Asset Management
Futures investing can involve significant risk, and is therefore not suitable for every investor. Past performance is not necessarily indicative of future results. Only risk capital should be used.
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