Are We In a New Market Regime? Why Diversified Funds Lost Value in May-June 2013

Posted on July 24, 2013 by

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You may have recently received a quarterly statement from your wealth manager or 401K provider and discovered that your low risk portfolio lost value. Many well managed funds experienced a similar dip. This dip was “special” and it may signal a transition to a new market regime. I’ll explain the drop, why it was special, and why there may be more dips like this until the transition is complete.

keywords: asset allocation, risk parity, diversified portfolio

Related post: Securities that may survive  interest rate risk

Background: Diversified portfolios include stocks and bonds

If your investments are managed by a wealth manager you likely hold a diversified portfolio that is designed to reduce risk. If your manager is good, he or she probably uses some sort of asset allocation or risk parity method for deciding how much should be invested in each asset.  Unfortunately, many such strategies lost value in May and June 2013. The loss may have come as a surprise to you because these types of management techniques are usually quite stable even if their overall returns are reduced compared to more risky strategies.

All managers of diversified portfolios use a blend of bonds and stocks, but their strategies differ according to how they choose to allocate funds between those assets. It is the complex relationship between stocks and bonds that explains the recent drawdown.  For this discussion, the distinctions between allocation strategies used by fund managers are not important.

Many well managed diversified funds were down in May and June

2013 Year to Date performance for The Cambria Global Tactical Fund (GTAA) and two of AQR's Risk Parity Funds (QRHIX and QRMIX).

2013 Year to Date performance for The Cambria Global Tactical Fund (GTAA) and two of AQR’s Risk Parity Funds (QRHIX and QRMIX). Note the decline in May and June.

Here’s a review of the performance of some leading asset allocation funds as of the end of June 2013:

  • The Bridgewater All Weather Fund, the granddaddy of risk parity funds, run by Ray Dalio: -5% in May, and -8% for the year. Stories in WSJ and Reuters.
  • The Darwin asset allocation strategy run by Macquarie Private Wealth: -5% in May.
  • The AQR Risk Parity MV fund: -3.5% in May and -9.0% in June. Overall -2.85% for the year. Their Risk Parity HV fund suffered similar losses and was -4.79% for the year. These funds are available as QRMIX and QRHIX.
  • Cambria Global Tactical Fund (GTAA): -3.8% in May, -3.4% in June and +0.74% year to date.
  • The StumpGrinder strategy I direct was also down in May and June, and down slightly for the year (more analysis on StumpGrinder to come in a separate blog).

Why were these strategies down?

From the June Reuters article:

The All Weather Fund … uses a so-called “risk parity” strategy that is supposed to make money for investors if bonds or stocks sell off, though not simultaneously. It is a popular investment option for many pension funds and has been marketed by Bridgewater and Wall Street banks as way to hedge market turmoil.

But money managers familiar with the strategy said it does not perform when both stock and bond prices tumble, as global markets have experienced in recent weeks.

That article was referring to the Bridgewater strategy, but the rationale for the drop applies to all the funds I listed above.

The importance of anti-correlation

An important reason these sorts of funds work well — and by that I mean low volatility and steady returns — is because they include assets whose returns are anti-correlated. Anti-correlated sounds like a complicated term, but its meaning is simple: When one asset zigs, the other zags.

Historically bonds (represented by AGG) and stocks (represented by SPY)  are anti-correlated (correlation is negative). Note the recent spike up in correlation that began in April 2013.

Historical correlation of bonds (represented by AGG) and stocks (represented by SPY). These assets are usually anti-correlated (correlation is negative). Note the recent spike up in correlation that began in April 2013.

Historically, bonds and stocks are anti-correlated (see chart), but they also both provide generally positive return in the long run. The combination of anti-correlation and positive return is key: It provides stable performance with low volatility.

These relationships broke down in May and June

Stock and bond prices dropped together and we transitioned from anti-correlation to a spike in correlation. Note that correlation reached a relative minimum (strong anti-correlation) in March but rose steadily from then on. (Topic for another blog: Could fund managers have detected the breakdown early?)

In May and June 2013 the major components of most asset allocation funds lost value: U.S. bond prices fell significantly along with international bonds and stocks. U.S. equities were the only source of positive return during this period, and even then only slightly positive. The overall market (S&P 500) was up, but low volatility stocks — the type often used in asset allocation strategies — were down significantly during this period.

What happened? The Fed’s policies have connected stocks and bonds in an unusual manner

The Fed’s policies since 2009 (low interest rates and bond buying) have served to drive investment to stocks in two ways:

  1. Low bond interest rates force investors to look to stocks and risky fixed income assets for reasonable return.
  2. Low interest rates enable investors to borrow money to buy more stocks and risky bonds than they might buy otherwise.

This combination of factors has contributed significantly to the bull market since 2009. Now, if and when interest rates rise these connections will trigger a steep decline across stock and bond assets as follows:

  1. Higher interest rates on new bonds will trigger price drops on existing bonds.
  2. New bonds will become more attractive, spurring rotation out of stocks.
  3. As borrowing costs rise, investors will have to unwind (sell) their positions in stocks and risky fixed income positions.

Those 3 factors taken together result in a simultaneous drop in bond and stock prices. We saw in May and June that the mere suggestion that the Fed might tighten money policy triggers this process. From an AP article:

Last month (June) stocks plunged after Bernanke said the Fed could slow the bond purchases later this year and end them next year if the economy strengthens. Since them, Bernanke and other Fed members have stressed that any change in policy depends on improvement in the job market and economy, not a target date. That has helped push stocks to new highs.

Outlook: We are between market regimes, bumps ahead

From 2009 until now stock and bond market interactions have been defined by the aggressive policies of the Fed, including at first low interest rates, then QE1, QE2, and QE3. Some people call this regime the “Bernanke Boom.” To some extent bond and stock prices have been decoupled because the Fed suggested that their easing policies will continue “for the foreseeable future.”

But we seem to be in transition now. The end of QE3 is concretely on the horizon. It seems that news (or even rumor) of Fed policy change will drive stock and bond prices more significantly than any other factor. Actual changes in policy are certainly ahead so we will see more market responses like the May/June dip in the future as they take effect.

Expect this relationship t0 continue until the Fed halts QE3 and takes a first step to raise interest rates. After that we’ll return to a more traditional market regime. Until then expect volatility in bonds and stocks.

Even with that volatility, for many investors asset allocation is still the best game in town. Asset allocation strategies have strong track records through many tough historical periods and I expect that record to continue.  However, until the Fed’s policy changes concretely, fund managers will have to think carefully about the instruments they use.

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