INVESTMENT INSIGHTS

The Quest for Defense

Yoram Lustig , Head of Multi-Asset Solutions, EMEA

Key insights

  • Most multi‑asset portfolios include a material exposure to global equities. Assets that diversify equity risk and perform well when equity markets perform poorly play a defensive role.
  • We propose a new metric—“protective score”—that quantifies and ranks the protective quality of assets with respect to global equities (or any other selected asset), considering the protection’s cost and effectiveness.
  • According to our metric, U.S. Treasuries would seem to offer the most effective diversification against equity risk.

Multi‑asset portfolios are usually heavily exposed to global equities. Even the performance of so‑called “balanced” portfolios—typically 60% equities and 40% fixed income and cash—is mostly determined by how well equities perform. To balance this, multi‑asset investors need assets that diversify equity risk and mitigate drawdowns. This presents two important questions: Which assets have been able to do this in the past? And which are likely to do so in the future?
 

To answer, we looked at the monthly returns of the MSCI All Country World Index (ACWI) over the last two decades, focusing on the months in which its return was negative. We then calculated the returns of various other asset classes during the months of the ACWI’s negative performance.

Even the performance of so‑called “balanced” portfolios... is mostly determined by how well equities perform.

U.S. Dollar‑Based Portfolios

Fig. 1 plots the performance of the ACWI (measured in U.S. dollars) and selected asset classes from February 1999 through June 2019. The x‑axis highlights performance over the whole period; the y‑axis illustrates performance during the 97 months in which the ACWI was in negative territory. While the annualized return of the ACWI during the entire period was 5.7%, the annualized return over the negative months was ‑36.0%.
 

The asset classes in Fig. 1 appear in three clusters. At the bottom right, risk assets are in the green rectangle. These include equities, real estate investment trusts (REITs), commodities, high yield bonds, and emerging markets debt. Over the past two decades, most of these assets have offered relatively strong returns overall. However, during months when the ACWI fell, these assets tended to fall as well.



(Fig. 1) U.S. Treasuries Proved Worth Over the Long Term 
The performance of the ACWI and selected asset classes in U.S. dollar terms February 1999 through June 2019

Graph: The performance of the ACWI and selected asset classes in U.S. dollar terms February 1999 through June 2019


Past performance is not a reliable indicator of future performance.

Sources: T. Rowe Price and selected indices. Returns are measured in U.S. dollars. Please see Tab. 2 Appendix for names of indices used.



The second cluster includes conservative assets—government and investment‑grade bonds and gold—positioned at the middle top of the chart in the orange rectangle. Some of the assets in this cluster have delivered attractive returns during both the entire period and, importantly, during months the ACWI has fallen. However, some of these assets have benefited from a secular drop in interest rates—something that should not be extrapolated into the future.
 

The third cluster (grey) shows currencies. They have typically delivered returns close to zero over the whole period. Some currencies are defensive, such as the U.S. dollar and Japanese yen; others, such as the euro and the British pound, are not. Emerging markets currencies, which do not appear on the chart, would not be defensive.

Assessing Protective Asset Classes

When considering how well an asset can “protect” another asset, two factors should be considered. The first is the excess performance of the “protective” asset when the “protected” asset falls. The objective is for the protective asset to generate the highest positive return when this occurs, or at least to outperform the protected asset during bad times. This factor indicates how well the protective asset performs when it is most needed.
 

The second factor is the opportunity cost of holding the protective asset. Assuming that the purpose of allocating away from the protected asset to the protective asset is to mitigate risk, the relative performance between the two matters. This factor indicates either the cost of protection (if relative return is negative) or the benefit of protection (if relative return is positive).


(Tab. 1) Determining an Asset’s “Protective Score”

Long-dated Treasuries offer better insurance against downturns
February 1999 through June 2019

Table: Determining an Asset’s “Protective Score”

 

Past performance is not a reliable indicator of future performance.

Souces: T. Rowe Price and selected indices. Returns are measured in U.S. dollars. Please see Tab. 2 Appendix for names of indices used.



The first factor less the second one gives a single number—the protective score—that captures the benefit of holding the protective asset less the cost of holding it. This single number allows for quick ranking of protective assets with respect to a chosen protected asset. While the factors are typically backward‑looking (ex‑post), they can be replaced with forward‑looking estimates (ex‑ante).
 

Tab. 1 includes the performance of assets over the entire time, their performance during months the ACWI had a negative return, and their protective scores. By definition, the ACWI—the protected asset—has a score of zero. U.S. Treasuries with a maturity of over 20 years have the highest score (54.7%), while European equity has the lowest score (‑11.2%).

The U.S. dollar and Japanese yen have been the most effective currency diversifiers of equity risk.

The Top Diversifiers of Equity Risk

  1. U.S. Treasuries. The classic diversifier of global equity risk is U.S. Treasuries. When equities are under stress, this can result in a flight‑to‑quality as investors rush to the safety of government bonds, causing yields to fall. As Treasuries are long‑duration assets (i.e., highly sensitive to interest rate changes), they deliver stronger performance when yields rally. Cash—with a duration close to zero—may not lose value when equities fall, but it also will not deliver a higher‑than‑average return over the short term.

    Over the past 20 years, U.S. Treasuries with maturities of 20 years or more have delivered the best returns during the negative months of the ACWI. The cost of holding long‑term bonds has been low as they performed well over the period, outperforming the ACWI.

    As Fig. 2 shows, rates have markedly fallen over this time, boosting the performance of Treasuries. Given the current low levels of interest rates, the ability of Treasuries to diversify equity risk going forward is likely to be more modest compared with the past two decades. Inflation has also fallen during this time. Bonds are protective in times of disinflation or low inflation but would offer less protection if the environment were inflationary.


  2. Currencies. The U.S. dollar and Japanese yen have been the most effective currency diversifiers of equity risk. Investors tend to rush to the safety of these two currencies when markets go through periods of stress. For U.S. dollar‑based portfolios, which are already mostly exposed to the U.S. dollar, the decision whether to hedge or unhedge foreign currencies, such as the euro and British pound, should consider whether to add exposure (hedge) or give up exposure (unhedge) to the U.S. dollar.

  3. Investment‑grade bonds. The Bloomberg Barclays Global Aggregate Bond Index, which tracks global investment‑grade bonds, has generally performed well when global equity performed negatively. The Bloomberg Barclays Global Aggregate Bond Index is an expansion of sovereign debt and may be a way to provide protection with a lower cost compared with that of government bonds, given their current low or negative yields.


  4. Gold. Gold has delivered positive returns when global equities have lost value. The performance of gold would be linked to inflation and real interest rates.

(Fig. 2) Falling Rates Have Boosted Treasuries
Yields from 1999 to 2019
As of June 30, 2019

Graph: Falling Rates Have Boosted Treasuries

 

Sources: T. Rowe Price and Bloomberg Index Services Limited (see Additional Disclosures).



Within equity markets, the U.S. equity market—and in particular, U.S. large‑cap value—has outperformed other regional markets when the ACWI suffered. The results suggest that U.S. equities are relatively defensive when compared with other equity markets, tending to outperform when global equities lose value.
 

Some fixed income asset classes, such as global high yield bonds and emerging markets debt, do not diversify equity risk. The role of these assets in multi‑asset portfolios should be to deliver income and potential capital gains. Their role is not conservative, and they are not poised to significantly mitigate equity risk. They do, however, have lower downside risk than equities.
 

Fig. 3 shows the cumulative performance of each of the mentioned asset classes and the ACWI during the 97 months in which the ACWI experienced negative performance.


Euro‑Based Portfolios

Fig. 4 repeats the exercise with returns measured in euros. The ACWI measured in euro registered 91 negative months from February 1999 to June 2019. This chart is also clustered into risk assets, conservative assets, and currencies. Fig. 5 shows the cumulative performance of some assets during the negative months of the ACWI.
 

Government bonds denominated in euros—such as German bunds—are commonly used to diversify against equity risk. However, some assets that traditionally have been diversifiers of equity risk, such as Italian government bonds, have not recently offered such protection. They have been behaving more like a risk asset since the 2011 European sovereign debt crisis.



(Fig.3) Long-Dated U.S. Sovereigns Deliver Stronger Performance for Dollar Investors

The ACWI versus U.S. Treasuries, the U.S. dollar, the Global Agg., and gold
As of June 30, 2019

Graph: The ACWI versus U.S. Treasuries, the U.S. dollar, the Global Agg., and gold As of June 30, 2019

 

Past performance is not a reliable indicator of future performance.

Sources: T. Rowe Price, MSCI (see Additional Disclosures), and Bloomberg Index Services Limited (see Additional Disclosures). Please see Tab. 2 Appendix for names of indices used.



(Fig. 4) Italian Government Bonds Appear to Deliver for Euro Investors

The performance of the ACWI and selected asset classes in euro terms
As of June 30, 2019

Chart: The performance of the ACWI and selected asset classes in euro terms. As of June 30, 2019

 

Past performance is not a reliable indicator of future performance.

Sources: T. Rowe Price and selected indices. Returns are in euros. Please see Tab. 2 Appendix for list of indices used.



We would normally advise to always hedge the currency exposure of foreign investment‑grade bonds denominated in developed currencies to the portfolio’s base currency. Otherwise, the volatility and drawdowns of the bonds imbed currency risk, often turning them from a conservative asset into a risky one. However, given current hedging costs of the U.S. dollar to euro, in the case of U.S. Treasuries, we would deviate from this golden rule. Holding Treasuries without hedging their currency in portfolios whose base currency is not the U.S. dollar provides exposure to two defensive assets: U.S. Treasuries and the U.S. dollar. While the volatility of unhedged Treasuries (10.2%) would be much higher than hedged ones (4.4%), holding unhedged Treasuries to diversify global equity risk could work well, as long as investors are comfortable with the volatility.



(Fig. 5) BTPs Deliver Stronger Performance Overall—But With Volatility 
ACWI versus Italian BTPs, German bunds, the U.S. dollar, and U.S. Treasuries
As of June 30, 2019

Graph: ACWI versus Italian BTPs, German bunds, the U.S. dollar, and U.S. Treasuries. As of June 30, 2019

 

Past performance is not a reliable indicator of future performance.

Sources: T. Rowe Price, MSCI (see Additional Disclosures), and Bloomberg Index Services Limited (see Additional Disclosures). Please see Tab. 2 Appendix for names of indices used.



(Fig. 6) U.S. and UK Sovereigns Provide Protection for Sterling-Based Investors

The performance of the ACWI and selected assets in UK sterling terms
As of June 30, 2019

Chart: The performance of the ACWI and selected assets in UK sterling terms. As of June 30, 2019

 

Past performance is not a reliable indicator of future performance.

Sources: T. Rowe Price and selected indices. Returns are in sterling. Please see Tab. 2 Appendix for list of indices used.

Some fixed income asset classes, such as global high yield bonds and emerging markets debt, do not provide diversification against equity risk.


(Fig. 7) Sterling-Denominated Treasuries Outperform

ACWI versus U.S. Treasuries (GBP), UK gilts, euros, and the Global Agg. Hedged GBP
As of May 30, 2019

 

Graph: ACWI versus U.S. Treasuries (GBP), UK gilts, euros, and the Global Agg. Hedged GBP. As of May 30, 2019

Sources: T. Rowe Price, MSCI (see Additional Disclosures), and Bloomberg Index Services Limited (see Additional Disclosures). Please see Tab. 2 Appendix for names of indices used.

UK Sterling‑Based Portfolios

Fig. 6 repeats the exercise, now with returns measured in UK sterling, and Fig. 7 shows the cumulative performance of selected assets during the negative months of the ACWI—96 such months when return is measured in British pounds.
 

The results are similar to those of a euro‑based portfolio. However, the two safe‑haven currencies have been the U.S. dollar and euro, rather than the Japanese yen. The British pound has greatly been affected by Brexit over the last three years, and it has greatly impacted the experience of currencies. Unhedged U.S. Treasuries have been an attractive way to diversify equity risk.


Safe‑Haven Currencies Appear to Offer Most Effective Diversification

Overall, it is clear from our analysis that given the current environment of low or negative interest rates of government bonds, investors might struggle to diversify the equity risk within their portfolios. Government bonds may still provide such diversification, but at higher costs than in the past because overall performance is unlikely to be as strong as it was when rates were falling. As such, safe‑haven currencies seem to offer the best potential for diversification. For portfolios with base currencies other than the U.S. dollar, unhedged U.S. Treasuries may also offer diversification, albeit at the cost of volatility.


(Tab. 2) Appendix

Indices used

Table: Appendix



Additional Disclosures

MSCI and its affiliates and third-party sources and providers (collectively, “MSCI”) makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.

Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

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