Asset Allocation in a Shifting Economy an Exploration of Testing Portfolio Allocations During Various Economic Scenarios

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Asset Allocation in a Shifting Economy An Exploration of Testing Portfolio Allocations during Various Economic Scenarios

By Amanda McQuain and Daren Easterling, PhD, CIMA®

iversification has long been can behave differently in various phases event in the economy, such as the burst recognized as essential in of the economic cycle. And, although of the housing bubble that caused the D reducing investment risk. the relationship between asset class 2007–2009 recession, or the savings and Modern portfolio theory teaches us that behavior and the economy is not cut- loan collapse of the early 1990s. The employing a number of asset classes and-dried, certain trends can be used as stock market crash and a string of bank with varying degrees of correlation can guidelines when building an all-weather failures in the 1930s caused the Great diversify away unsystematic risk and, portfolio. Depression, the most notable recession consequently, dampen overall portfo- The key factors that define different in U.S. history. During these periods of lio volatility. By having exposure to low economic environments are real gross slow or negative growth, a combination or negatively correlated asset classes, domestic product (GDP) growth, infla- of increased government spending and an investor will, in theory, always have tion, interest rates, and the unemploy- an intentional lowering of interest rates some winners and some losers in a ment rate. Four primary environments may be used to help stimulate the econ- portfolio. are addressed here: recession, stag- omy. As the economy begins to recover Indeed, asset allocation is one of the flation, inflationary growth, and ideal from a recession, it enters an expan- primary values an advisor offers to cli- growth. Figure 1 shows the relation- sionary period where GDP is steadily ents. Advisors understand the impor- ships of these different factors and the growing but inflation stays relatively tance of appropriately selecting and environments they create. low. This was the case in the post-war weighting asset classes for clients to Recession. A recession is technically era of the 1940s, as shown in figure 2. receive a portfolio with certain agreed- defined as two consecutive quarters of Stagflation. Stagflation occurs as upon risk and return characteristics. negative gross domestic product; how- inflation and unemployment begin Conversely, these agreed-upon risk ever, it generally lasts six to 18 months to rise, but the industrial growth rate and return characteristics help deter- and is accompanied by high unem- remains low. The most prominent mine a suitable asset allocation for a ployment and low inflation. Recessions period of stagflation in the United client. Nevertheless, all of this work most often are caused by a significant States occurred through the 1970s, as toward proper diversification relies on FIGURE 1: ECONOMIC ENVIRONMENTS the assumption that expected risk and return is based on the occurrence of a normal market environment. Clients are presented with allocations that WARM HOT reflect assumptions of normal market (Ideal Growth) (Inflationary Growth) conditions; yet clients are concerned about market conditions that are any- thing but normal. To manage client concerns and COOL COLD guide them through a long-term invest- Economic Growth (Recession) (Stagflation) ment strategy, it is important to understand potential deviations that asset classes might experience in different Inflation economic environments. Asset classes

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fiscal and monetary policies were used FIGURE 2: INFLATION AND GROSS DOMESTIC PRODUCT, 1930–2012

to increase the money supply but pro- 19 18 17 duction remained low. Inflation rates 16 15 14 were north of 10 percent throughout 13 12 11 much of the decade, with GDP remain- 10 9 ing low to negative. High unemploy- 8 7 6 ment and high inflation create an envi- 5 4 3 ronment where there is less money to 2 1 0 be spent and the value of that money -1 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 -2 -3 has decreased. -4 -5 -6 Inflationary growth. During stag- -7 -8 flation, Keynesian theory suggests that -9 -10 -11 fiscal and monetary policy is neces- -12 -13 -14 sary to influence demand, and there- -15 fore, economic growth. By increasing Recession Expansion Stagflation Ideal Growth Inflation GDP based on chained 2005 dollars spending or implementing tax breaks, Source: U.S. Department of Labor for CPI (inflation) and Bureau of Economic Analysis for GDP money flows into the economy and increases demand, which in turn raises GDP. Inflationary growth occurs when diversification remain as the answer fall behind. Bull markets tend to pro- inflation rates stay higher than normal to mitigate downside risk regardless of duce positive returns in most diversi- but steady, and GDP begins normaliz- the economic environment? To answer fied portfolios, and bear markets pull ing, to somewhere around 4 percent. these questions, it is important to back and offer flat or negative returns At this point the economy is stabilizing, understand the behavior of the various over time. and inflation will come back to healthy asset classes. Because the market frequently shifts levels. between these highs and lows, a portfo- Asset Classes are Cyclical Ideal growth. As inflation rates lio should be developed to weather the begin to come back to normal and GDP Every asset is cyclical, in that it will various cycles and still produce attrac- begins to recover, the economy enters lead the economy, track it, or lag it. As tive returns. Because it is nearly impos- into ideal growth. Here, the economy such, forecasting an asset class’s perfor- sible to predict when the next cycle is has just the right balance. Inflation is mance from one environment to a dif- coming, it can be a challenge to build generally low at less than 3 percent, and ferent environment can be dangerous. a portfolio that can withstand what’s GDP is consistently around 4 percent. Leading assets already will be in the to come. Often the current economic This phase is the most desirable of the beginning stages of a bull market when environment isn’t identified until it’s economic cycle. If the trend of rising a recession is ending. Bond yields, for too late to make a beneficial switch in growth continues, the economy over- example, will begin to rise ahead of an the portfolio. While one allocation may heats, which leads to inflationary equity bull market. Meanwhile, lagging perform well in a low-inflation environ- growth. Demand is outpacing supply, assets will still have some downtime ment, it may drastically underperform and prices are beginning to rise. left before they start to recover. We see during periods of high inflation. That Inflation moves upward of 5 percent. these cycles as the economy oscillates then becomes the challenge. When At this point the government may raise between expansion and contraction, clients want to buy or sell based on the interest rates to cool off the economy, bull and bear, and monetary easing and current environment, they may be too which in turn reduces spending. As tightening. While U.S. large-cap equi- late to the game to benefit; the change spending decreases, production slows, ties thrive during rising growth and low may be detrimental. Again, is diversifi- unemployment rises, and the economy inflation, commodities typically under- cation over the long term still the right moves through the natural cycle and perform because a lack of inflationary choice, or does reacting to economic begins to show signs of a recession. pressure keeps the prices of real goods cycles better mitigate downside risk? As the economy ebbs and flows low. By the same token, falling growth Systematic vs. Unsystematic through these cycles, the return and and rising inflation provides the per- Risk volatility patterns of asset classes also fect environment for commodities and ebb and flow. So, can a particular allo- emerging markets to outperform while In either approach, the building blocks cation withstand these cycles and, if a weakening dollar and high unem- of portfolio construction should be so, how should it be structured? Does ployment cause the domestic market to composed of some combination of risk

factors and asset classes. Every asset lagging or coincident, which means that For instance, the best-performing class carries risk that can broken into by the time the current cycle is recog- asset classes during a recession tend systematic (the risk inherent in the mar- nized, it is generally too late to make a to be municipal bonds, U.S. aggregate ket) and unsystematic (the security- constructive allocation change. So what bonds, and real assets (commodities). If specific risk unique to that security). about using leading indicators to pre- unemployment is rising, interest rates Although unsystematic risk can essen- pare for a downturn? A common guide- are falling, and consumer spending is tially be diversified away by holding an line is that three consecutive declines in slowing, this signals a good time to shift array of securities in the portfolio, sys- three months signals a recession; how- a portion of the equity allocation to tematic risk, such as inflation, interest ever, this guideline has sent at least one high-quality bonds and real assets such rates, and commodity prices, affects the false signal in six of the eight expansions as gold (a commodity that performs whole market and cannot be avoided that came before February 2005. For well in a recession). Assuming a 60-per- through diversification. this reason, many economists now pre- cent U.S. large-cap/40-percent aggre- Forward-looking capital market fer to see a sharp, prolonged decline in gate bond portfolio has a standard devi- assumptions can be developed for each the Leading Economic Index, accompa- ation of 12.4 percent and an expected asset class’s systematic risk and corre- nied by declines in all 10 components.1 three-year return of –7.8 percent in a sponding return by addressing the long- Because there is so much downturn recessionary environment, a shift of 10 term market conditions around these required before a meaningful assess- percent of the equity allocation to com- factors. For example, a base case set ment can be made, using leading indi- modities and 10 percent to municipal of capital market assumptions is cre- cators to make portfolio changes based bonds lowers the standard deviation ated assuming a normal market envi- on a forecasted upswing or downswing to 9.1 percent and increases the return ronment with constant GDP growth almost can guarantee a spot behind the to –5.2 percent. A higher allocation and moderate inflation. Then it is deter- eight ball. While tracking these indica- to high-quality fixed income, or man- mined how each area of the market, tors certainly can suggest the future of aged futures, would produce a more i.e., asset class, should perform under the economy, making small indicator- significant impact; however, this exam- these normal conditions from a return based shifts within a well-diversified ple illustrates that even small, timely and risk perspective. From this base portfolio will better position clients for changes can have a noticeable improve- case set of assumptions, a different set the long-term ups and downs. ment on the portfolio in even the worst of assumptions can be developed for scenario. On the other hand, consider Return Augmenters or Risk each economic environment as a devi- the same 60/40 portfolio as a starting Moderators ation from the base case set. In other point in an inflationary growth environ- words, by considering how the key fac- Most asset classes can be categorized as ment. As inflation and interest rates are tors in each market environment fluc- either return augmenters or risk moder- rising, fixed income will begin to suffer tuate, a set of adjusted forward-looking ators. While return augmenters offer the and a shift back to equities with things risk and return assumptions for each of highest returns, they also typically carry such as emerging markets and private the different scenarios can be created. the highest standard deviation. Examples equity sprinkled in will create an ideal For example, in a stagflationary envi- include emerging markets, interna- allocation to benefit from this hot environment, the three-year return on U.S. tional small-cap, and U.S. large-cap. Risk ronment. The 60/40 portfolio would be large-cap equities would be reduced 890 moderators are those asset classes that expected to have a standard deviation bps, from 7.7 percent to –1.2 percent. offer protection with single-digit stan- of 12.4 percent with a three-year return These assumptions then can be used dard deviation, which generally equates of 1.7 percent. By moving 10 percent in the institutional process of building to the lowest returns. Examples include from fixed income to emerging market portfolios. municipal bonds, U.S. aggregate bonds, equities, and another 10 percent to pri- As mentioned, reacting to eco- and managed futures. Maintaining the vate equity, the standard deviation has nomic cycles is a risky game, because appropriate balance in the portfolio is increased slightly to 16.2 percent, but each asset class has a different and key because protection in the down mar- the return has increased more dramat- often unpredictable reaction to an eco- kets should not come at the expense of ically to 5.3 percent. These two exam- nomic swing. Many times, identifying missing out on participating in up mar- ples are simple, and the majority of the direction of the market, and there- kets. This may result in small modifica- the equity allocation in both remained fore the asset class(es) headed for an tions within the overall portfolio along in U.S. large-cap. When that alloca- upswing, is difficult and untimely. More the way; however, these modifications tion is spread out among several other than half of the economic indicators should be short-term and in response to subclasses, the results become more published by The Conference Board are an anticipated economic shift. positive.

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Figure 3 and table 1 show a diver- FIGURE 3: DIVERSIFIED ALLOCATION sified portfolio that uses a balance of the return augmenters and risk mod- 5% 5% erators plus forward-looking assumptions with the expected three- and five- 13% Global Real Estate year performance in each environment. Commodities It is also compared to a standard 60/40 2% Cash 30% allocation. TIPS 5% As shown in figure 3, the diversified Emerging Market Bond High Yield Bond portfolio outperforms the standard allo- U.S. Aggregate Bond 10% cation in all instances. It is not surpris- Emerging Markets ing to see that both portfolios perform International Small Cap similarly in an ideal growth environ- U.S. SMID Cap 5% 5% U.S. Large Cap ment. As the name suggests, this is the 5% Managed Futures most desirable scenario and almost all 10% 5% asset classes are performing well. Ideal growth is also generally the shortest- lasting environment, because it tends TABLE 1: DIVERSIFIED ALLOCATION to be a pass-through period while the Three-Year Five-Year economy is shifting. Because the for- 60/40 Diversified 60/40 Diversified ward-looking assumptions for each sce- Ideal Growth 13.2% 14.0% 10.4% 11.0% nario normalize over time, the shorter- Inflationary Growth 1.7% 5.2% 4.9% 7.0% term returns are higher and drop Stagflation –2.9% –0.1% 0.9% 2.6% slightly as the economy normalizes. The Recession –7.8% –7.7% –3.7% –3.4% same is true in a recession. In times of extreme downturns, almost all asset classes will drag, though the diversified scenario, how the return augmenters range of investments with low correla- portfolio shows slightly better returns and risk moderators interact, and how tion, because as some are aggressive in in both time frames. It would be most to gauge an allocation change based up markets, others protect in down mar- beneficial during extreme downturns to on an expected shift in the economy, kets. Low correlation achieved through slightly overweight the overall portfolio it is clear that a strategic approach to diversification provides balance. For in fixed income and other protectors. investing is best because no one knows example, while the S&P 500 fell 57 per- The most prominent differences can be which asset classes will be the winners cent between late 2007 and early 2009, seen in inflationary growth and stag- in the future. Being cognizant of how Treasury bonds gained 21 percent and flation. Over a three-year stagflation the market behaves under various eco- short-term investments produced small, period, returns go from negative to flat, nomic conditions can provide insight but positive returns.2 and even more notably, gain 350 bps as to how different asset classes might As 2008 and 2009 asset class corre- during inflationary growth. The long- react, and will help to better position lations moved closer to 1.0, diversifica- term standard deviation also reduces the portfolio to thrive across all market tion advantages were eradicated. Such quite noticeably, from 12.4 percent to conditions. events can instill fear in clients and 11.1 percent. Because of the long-term True diversification involves a make them question whether a diver- nature of assumptions, standard devi- broad range of asset classes, sectors, sified portfolio provides any benefit at ation is expected to be constant over and investment vehicles. It includes all. However, in such times it is impor- time. It also should be understood the major asset classes—equities, fixed tant to focus on the long-term horizon that the return and standard deviation income, and cash—and also delves into and remember that periods of high cor- assumptions assume a normal recov- various subclasses, precious metals, cur- relation and low return are an expected ery and smoothing out of each scenario rencies, commodities, and so on. To take phase of an economic cycle. Periods of over time. full advantage of the benefits of correla- high turbulence in the markets are fol- tion and a risk-return balance, a portfolio lowed by stabilization and then recov- Strategic Approach to Investing should be diversified over as many differ- ery, and significant gains can be earned After examining the performance of dif- ent sources of return as makes sense for by owning a broad portfolio in those ferent asset classes in each economic the client. Value is added through a wide Continued on page 54

target date fund actually may increase markets, in London, on Wall Street, McQuain– tail risk, while including MBS in an and in academia. He earned a PhD aggressive target date fund, even at rel- from Cambridge, and MS degrees Easterling atively high levels, appears to reduce in finance, economics, and statis- Continued from page 50 long-term tail risk. tics, and a master of research in computer vision, image processing, Concluding Comments simulation, and graphics, all from Using data from 1976–2009, we find the University of London. Contact times. The S&P 500 was up more than that the inclusion of MBS in a life-cycle him at [email protected]. 26 percent in 2009, its greatest gain portfolio would be expected to reduce since 2003, after being down 37 percent References terminal real wealth relative to an MBS- in 2008.3 As important as it is to pro- free portfolio. The extent of the erosion Employee Benefit Research Institute vide portfolio protection for clients, it is dependent on both the nature of the (EBRI). 2002. An Evolving Pension is equally important to ensure they do life-cycle glide path and the proportion System: Trends in Defined Benefit not miss out these market gains. The of the fixed income glide path allocated and Defined Contribution Plans. EBRI purpose of diversification is to mitigate to MBS. Volatility of terminal wealth Issue Brief No. 249 (September). http:// these risks and take advantage of these is reduced, but the risk of retirement www.ebri.org/publications/ib/index. opportunities over the long term. MIDSTREAM wealth shortfall is increased and rises cfm?fa=ibDisp&content_id=166. rapidly as the allocation of the fixed ———. 2008. Total Individual Account Amanda McQuain is an investment income glide path to MBS increases. Retirement Plan Assets. EBRI Notes research specialist for the Institute This could be important if investors 29, no. 3 (March). http://www. of Investment Management equate risk with volatility. We further ebri.org/publications/notes/index. Consulting, Portfolio Management Upstream Midstream Downstream find the impact on the risk of a short- cfm?fa=notesDisp&content_id=3899. Group at Raymond James, where fall in retirement is dependent upon the Financial Research Corporation (FRC). 2007. she serves as the team lead in nature of the glide path. Inclusion of Lifecycle Funds Quarterly Report 4, no. 3. researching scenario analysis and MBS into very conservative target date http://www.frcnet.com/periodicals.html. risk budgeting. She earned a BS in funds actually may increase the risk of Investment Company Institute (ICI). 2007. The finance from the University of South a shortfall in retirement wealth, while U.S. Retirement Market, 2006. ICI Research Florida. Contact her at amanda. We are your inclusion in an aggressive target date Fundamentals 16, no. 3. http://www.ici.org/ [email protected]. fund, even at relatively high allocations pdf/fm-v16n3.pdf. to MBS, reduces this shortfall risk con- Lewis, N. D. 2008a. Assessing Shortfall Risk Daren Easterling, PhD, CIMA®, is energy income stream siderably. This is an important finding in Life-Cycle Investment Funds. Journal of the director of investment consulting for two reasons. First, because investors Wealth Management 11, no. 1: 15–19. for Raymond James’ Asset Manage ® typically choose portfolios as if they ———. 2008b. The relationship between tar- ment Services. She earned a BS in Cushing offers you the most important resource of all when it comes to energy income are more concerned about losses than get date and target risk funds. Pensions: An psychology from the University of gains (see, for example, Rabin 2001). International Journal 13, no. 1 and 2: 55–60. Southwestern Louisiana, an MA investing—knowledge and experience. Our people, process, and disciplined approach Second, portfolio managers, plan spon- ———. 2008c. Making ends meet: Target date in psychology from the University to portfolio management can help you reach your goals in energy income investing. sors, and investment advisors may not investment funds and retirement wealth cre- of Texas at El Paso, and a PhD in be aware of the nature of the relation- ation. Pensions: An International Journal 13, industrial/organizational psychol- ship between target date fund glide no. 3: 130–135. ogy from the University of South MLPs | Upstream MLPs | Royalty Trusts | U.S. Energy Renaissance Securities paths, allocations to MBS, and future Rabin, Matthew. 2001. Risk Aversion and Florida. Contact her at retirement wealth. If the realized mean Expected-Utility Theory: A Calibration [email protected]. returns and co-variances generated by Theorem. Econometrica 68: 1,281–1,292. Endnotes the simulation period are good esti- Shiller, Robert J. 2005. Life-Cycle Portfolios as mates of the future values of these Government Policy. The Economists’ Voice 1 See http://www.investopedia.com/univer- quantities, then it can be argued that 2, no. 1, article 14. http://www.philadelphi- sity/conferenceboard/conferenceboard2. MBS is likely to prove to be a poor stra- afed.org/research-and-data/events/2005/ asp#axzz1tSSqJlKQ. tegic diversifier, although it may have a fed-policy-forum/papers/Shiller_lifecycle- 2 See https://guidance.fidelity.com/ role on a tactical basis. portfolios.pdf. investors-quarterly/ Viceira, Luis M. 2007. Target date investment does-diversification-still-work-acc. Nigel D. Lewis, PhD, has many years funds. Available at SSRN: http://ssrn.com/ 3 See www.standardandpoors.com. work experience in the financial abstract=988362. 877.965.7386 | CushingMLP.com

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