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Investment Insights

The Quest for Defense

How can you diversify against global equity risk?

Yoram Lustig, CFA, 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.

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

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.

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.

(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

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.

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).

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%).

(Tab. 1) Determining an Asset’s “Protective Score”
Long-dated Treasuries offer better insurance against downturns
February 1999 through June 2019

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

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

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

The Quest for Defense

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.

Important Information
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.

© 2019 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the Bighorn Sheep design are, collectively and/or apart, trademarks of T. Rowe Price Group, Inc.


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