During a recent backyard barbecue with family and friends, I looked up from behind the grill at the dozen or so kids and was struck by how similar siblings looked to one another. Within sets of siblings, each child was distinct yet shared unmistakable features. Think of asset classes like siblings. They are clearly distinct. High-yield bonds and large-cap U.S. stocks, for example, are entirely different types of securities. With bonds, investors expect to receive an income stream plus interest (and potentially capital gains). With stocks, the opportunity is capital gains plus any dividends the companies may pay. Yet despite their differences, these asset classes are siblings. The performance characteristics of high-yield bonds and large-cap U.S. stocks are correlated—that is, relate to one another—especially when there is stress in the market.
Covid market stress
The Covid shock at the beginning of 2020 is a good example of how these “sibling” asset classes tend to demonstrate their “relatedness” when under stress. The following chart plots the daily change in yield for the ICE BofA US High Yield Index against the change in return for the S&P 500 from January 1, 2020 to March 20, 2020. Draw a line with your eye through the dots. The line is upward sloping from the left to the right, showing a clear correlation. As the markets sold off quickly, bond yields rose (which lowered the bond prices shown on the graph) and stocks fell.
Implications for portfolio construction
This relatedness is not limited to high yield and equities. Many asset classes share similar risk-return characteristics—to a degree that thinking in terms of “risk factors” is just as important, if not more important, than thinking in terms of “asset classes.” Without attention to overlapping risk characteristics, an investment manager might inadvertently put too many eggs in one type of basket, working against the inherent benefits of diversification—and thereby increasing overall portfolio risk. At Johnson Financial Group, our approach emphasizes portfolio construction based on different “risk families.” We apply sophisticated tools to help us monitor portfolio risk and, critically, to understand how assets will behave in different market stress scenarios. Harry Markowitz, Nobel laureate and father of Modern Portfolio Theory, once said “diversification is the only free lunch in investing.” His point was to increase the diversification of risks inside your portfolio…not just the names of various security types. So, understanding how assets relate to one another is essential to achieving that “free lunch” of an improved risk/return profile via diversification. Have a great rest of your summer. Just don’t forget to take your kids home after the barbeque. I know which ones are yours because they look just like you.