Asset Allocation

The Quest for Defense

October 3, 2019
How can you diversify against global equity risk?

Key Points

  • Most multi-asset portfolios are heavily exposed to global equities, which means they require assets that diversify against equity risk.
  • We propose a new metric—“protective score”—that quantifies the protective quality of assets with respect to global equities.
  • According to our metric, U.S. Treasuries 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.

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).

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%).

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 provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of September 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. Diversification cannot assure a profit or protect against loss in a declining market. All charts and tables are shown for illustrative purposes only.

201910-967671

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