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“Advisors should consider using new tools to manage correlation extremes to improve diversification in client accounts and portfolios.”

Diversification isn’t to blame for portfolio breakdowns: Don’t just blame bonds, it’s faulty modeling.

Much has been made of how the traditional 60/40 portfolio has failed. But what is interesting is the contortions the industry has made to blame the lack of diversification performance on the need for greater asset class diversity, active manager failure, or even too high fee levels. Whole new sets of tactical asset allocation approaches have sprung up over the last 10 years, the most notable being risk parity and its derivatives. The simple truth is that even with increased asset classes and new age tactical approaches, investors depending on asset allocation to meaningfully reduce losses when equity markets fall have been disappointed. Our view is clear. As long as the same diversification techniques and approaches are used without dealing with the core problem of these models, investors should continue to be disappointed. It doesn’t have to be remain such. Many think low interest rates on bonds are the only culprit but it’s more nuanced than just a bond issue. First let me explain what we view as the main problems before we discuss what investors and allocators can do about it.

Problem #1- Yes, diversification’s free lunch has a nasty after taste when seasoned by low interest rates

Investment regimes have a major impact on how diversification works. For example, when 10-year Treasury bills yield 5% (as just prior to the Great Recession of 2008-2009) there is a notably more significant defensive quality to fixed income against equity declines. For example, a 10% annual decline in equities in a 60/40 portfolio would translate to 6% impact in a 60/40 portfolio (-10% x60% allocation). But that loss would be offset by the bond coupon to the tune of +2% at the portfolio level (5% annual coupon X 40% allocation). So, the net impact from a -10% equity decline could be as little as a -4% impact. Now we know that in 2008 long US Treasury bonds (10-20-year Bonds for ex:) returned almost 34% with equities down 37% over that period, that’s a nice offset. Because interest rates were relatively high there was significant scope for the bonds’ prices to rise if interest rates dropped in response to what drove down equities. As a result, in higher interest rate regimes the diversification benefit of bonds is clear. But when bond yields are lower let’s say sub 1% like today, the diversification value of bonds is impaired because the multiplier of dropping rates is just smaller. As a result, balanced portfolios don’t really provide enough protection. Therefore, the natural offset to equity losses can be significantly minimized.

A corollary to the problem of low rates is that these regimes often cause investors to increase their allocations to credit strategies in pursuit of higher rates of return. Because there is less certainty of repayment as credit quality is reduced, these bonds don’t behave as defensively as Treasury bonds. As credit quality moves towards high yield or junk quality, the correlation of these bonds (or their pattern compared to equity) start to perform more like equity than treasuries. This is primarily because the sensitivity (credit convexity) of credit to interest rate moves and economic data can be very different than that of treasuries. Looking back at 2008, High Yield bonds were down over 17%. While HY bonds yielded close to 9% at that time, that coupon did little to protect investors as HY started to correlate to equities. That’s because the convexity of credit really kicked in during that period. So, interest rates alone can’t protect one.

Problem #2- Correlation is a more dangerous enemy than volatility.

Many advisors and portfolio managers have been taught that outside of target return, volatility is the most important factor to manage for clients. We disagree and think correlations are actually more important. Believe it or not there are many periods where volatility levels may rise but that in and of itself doesn’t hurt returns (just look at 2019). More often, however, it’s when correlation assumptions prove faulty that overall investor returns are damaged. So, in our opinion correlation management is much more important than a pure volatility approach. But what is correlation? Correlation is the statistical relationship between two variables (in this case the asset or fund we are measuring against the S&P 500) and whether the variables move in positive tandem or opposite each other. A positive correlation exists when one variable decreases as the other variable decreases, or one variable increases while the other increases. While not a topic for this article, it’s important to note that most asset allocation models normalize asset class or fund returns under gaussian assumptions. That ends up changing the way model’s blend funds and may complete neutralize some of the skewness (which can be good) in their returns’ correlations. But letting that fact go for a moment, asset allocation diversification depends powerfully on some measure of multi-asset low to negative correlation. The assumption of asset allocations inter-asset or inter-fund low or reduced correlation is a critical factor for diversification that must be verified. The hope of asset allocation diversification is that if an investor builds greater diversification into a portfolio its sensitivity to equity declines should drop. But the data we see is not justifying that view. What we see instead is that portfolios with reduced equity allocations (even when formulated for lower volatility), like the traditional 60/40 (or 60/35/5 as we use in our charts below), are actually correlating at much higher levels to equity performance (see chart below). As a result, when diversification is needed most it may actually be failing. The charts below show the actual performance correlation to the S&P 500 of a balanced 60/35/5 portfolio (60% SPX, 35% 10-20-year Treasury), and 5% HY index).

The following can be seen or inferred from the chart:

60/35/5 Portfolio and JDIEX correlation to SPX (SPX actual performance in green for reference)

Bloomberg Data and EAB Investment Group

Past Performance is no guarantee of future results. Investors cannot directly invest in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

In fact, since 2015 the 60/35/5 portfolios have correlated to equities at well over 80% a great deal of the time. That’s a concern if one assumes that portfolio allocations (60% equity, 35% treasury bonds, and 5% High Yield) are representative of how they will actually perform. If you are wondering, balanced accounts including international assets or funds don’t actually look different. But just as problematic is that often when the S&P was in decline the balanced portfolio’s correlation to equities rose when one would hope for diversification. In contrast, an option-based fund EAB Investment Group manages, JDIEX (the orange line) maintained more stable correlation under normal conditions but dropped when equity markets were in meaningful decline. This can translate into a more diversifying signature for an investor’s performance because this may lower portfolio correlation in difficult times.

Another approach to managing correlations is to expressly add components to one’s portfolio that benefit from multi-asset correlation expansion typical when crises or volatility rises. Multi-asset or sector correlation expansion is a dangerous event for portfolios. Many funds’ realized correlations to equities increase in such circumstances. A new approach, the Correlation Defense Index- CDI™, provides a low volatility positive carry under normal market conditions but is designed to provide additional defensive returns under market stress within a positive carry framework. The chart below shows the pattern of that index vs the S&P using a proprietary systematic correlation expansion opportunity approach to diversification.

EABCDI Performance scaled vs SPY shows benefits of low to negative correlation

(SPY left scale and EABCDI on right scale, CDI daily spikes shown in gray)

EAB Investment Group

Past Performance is no guarantee of future results. Investors cannot directly invest in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

The following can be seen or inferred from the chart above and below:

  • Correlation expansion-based approaches may provide a diversifying signature to equity returns particularly under equity declines
  • EABCDI shows spike potential and reactivity to more than simple equity decline.
  • EABCDI correlation to equities stance in the -.3 to -.5 range, particularly when equities under stress, can be a useful tool for overall portfolio diversification. 

EAB CDI Correlation to SPY (2008 to February 2020

EAB Investment Group

Past Performance is no guarantee of future results. Investors cannot directly invest in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

So, we believe that lowering volatility won’t solve the asset allocation model portfolio problem- managing portfolio correlations does. We believe that using an active options-based strategy that asymmetrically addresses downside and reduces equity correlation looks powerful as does adding innovative systematic multi-asset correlation defense. We believe this will be both intuitive and more behaviorally effective in keeping investors allocated through hard times.

Problem #3. The risks Credit and High Yield add to portfolio diversification

As stated before, the lower the credit quality on bonds the more they start to correlate to the S&P 500. At the moment HY possesses an approximately 75% correlation to equity. In contrast US treasuries normally correlate between zero and -40%. That difference, particularly if credit or HY is a big part of a portfolio, can be very damaging to expected diversification. The following can be noted from the chart below:

  • High Yield correlations to SPX routinely run in the 60%+ range and aren’t stable.
  • Past 4 years of HY spread tightening versus US Treasuries and dropping interest rates in general has increased HY correlation to equity to ~75%.
  • Consider the impact yield seeking has on asset allocation stability that options-based strategies seek to mitigate.

60/35/5 Portfolio and High Yield Index (Iboxx Hy) Correlation to SPX

(SPX actual performance in green for reference)

Bloomberg Data and EAB Investment Group

Past Performance is no guarantee of future results. Investors cannot directly invest in an index and unmanaged index returns do not reflect any fees, expenses or sales charges.

Current conditions in the credit markets, the recent pull back include relatively low spreads over comparable treasuries and because equity levels have been partly elevated by the low interest rate environment a positive feedback loop has been created. Low interest rates have therefore fueled buybacks which in turn have improved equity to debt ratios. This cycle increases the correlation of credit to equities and exposes credit to greater declines if this loop is reversed.

Summary: Portfolio Diversification isn’t the problem- It’s poorly managed correlation.

Advisors should consider managing correlation extremes to improve diversification in client accounts and portfolios. It’s time the industry stopped using Co-variance matrices that assume stability and serial correlation (where tomorrow’s correlation is more likely to look like today’s). We think advisors should seek out the tools based on new statistical techniques and products (like options-based funds and multi-asset correlation management approaches) that seek to create better downside risk management and therefore portfolio diversification than traditional asset allocation models. To summarize:

  • Investors should ask questions about what correlation assumptions are built into their models.
  • Have any optionality or managed correlation products have been considered to meet their needs.
  • Substituting portions of the core equity allocation and credit allocations for defensive downside options-oriented approaches, investors may regain the diversification they target.
  • Stretching for yield aggressively and/ or using core S&P passive approaches may not defend downside risk the way correlation and volatility mitigating strategies do.
  • Stabilizing returns under stress and minimizing volatility drag, sequence of event risk, and disappointing datapoints could improve investor model compliance.

One day, interest rates might rise again to diversifying levels. Credit spreads, similarly, may also return to historically wider levels. But until they do, why should diversification remain impaired? We think the answers are clear and the results obtainable….

Barclays U.S Corporate High Yield Bond Index: is composed of fixed-rate, publicly issued, non-investment grade debt.

Gaussian process: is a stochastic process (a collection of random variables indexed by time or space), such that every finite collection of those random variables has a multivariate normal distribution, i.e. every finite linear combination of them is normally distributed.

iBoxx USD Liquid High Yield Index: consists of liquid USD high yield bonds, selected to provide a balanced representation of the broad USD high yield corporate bond universe. The index is used as a basis for tradable products, including ETFs.

S&P 500 Index: An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

  YTD 1-Year 3-Year Since Inception: 7/31/2015
I Shares 12.11 12.11 6.68 4.63
S&P 500 31.49 31.49 15.27 12.50
Morningstar Options Based Category 14.69 14.69 5.09 3.86

Returns through 12-31-2019 data provided by Zephyr

All returns are quoted as annualized if over 1 year.

Performance data quoted above is historical. Past performance does not guarantee future results and current performance may be lower or higher than the performance data quoted. The investment return and principal value of an investment will fluctuate so that shares when redeemed may be worth more or less than their original cost. The Fund’s management has contractually waived a portion of its management fees until December 31, 2019 for I Shares. The performance shown reflects the waivers without which the performance would have been lower. Total annual operating expenses before the expense reduction/reimbursement are 1.37% for I Shares; total annual operating expenses after the expense reduction/reimbursement are 1.19% for I Shares. For more performance numbers current to the most recent month-end please call (888) 814-8180.

RISKS AND DISCLOSURES

No amount of diversification or non-correlation can ensure profits or prevent losses. 

The portfolio will borrow money for investment purposes. Leveraging investments, by purchasing securities with borrowed money, is a speculative technique that increases investment risk while increasing investment opportunity. Derivatives may be volatile, and some derivatives have the potential for loss that is greater than the Portfolio’s initial investment. If the Portfolio sells a put option, there is risk that the Portfolio may be required to buy the underlying investment at a disadvantageous price. If the Portfolio purchases a put option or call option, there is risk that the price of the underlying investment will move in a direction that causes the option to expire worthless. The Portfolio’s ability to achieve its investment objective may be affected by the risk’s attendant to any investment in equity securities.

The securities of issuers located in emerging markets tend to be more volatile and less liquid than securities of issuers located in more mature economic structures and less stable political systems than those developed countries. Shares of ETFs have many of the same risks as direct investments in common stocks or bonds. In addition, their market value is expected to rise and fall as the value of the underlying index or bond rises and falls. It is possible that the hedging strategy could result in losses and/or expenses that are greater than if the Portfolio did not include the hedging strategy. The use of leverage by the Fund or an Underlying Fund, such as borrowing money to purchase securities or the use of derivatives, will indirectly cause the Fund to incur additional expenses and magnify the Fund’s gains or losses. Because a large percentage of the Portfolio’s assets may be invested in a limited number of issuers, a change in the value of one or a few issuers’ securities will affect the value of the Portfolio more than would occur in a diversified fund.

Past performance is not a guarantee or a reliable indicator of future results. Investors cannot directly invest in an index and unmanaged index returns do not reflect any fees, expenses, or sales charges. As with any investment, there are risks. There is no assurance that the portfolio will achieve its investment objective. Mutual funds involve risk, including possible loss of principal. Certain members of James Alpha Advisors, LLC are also registered representatives of FDX Capital, LLC, member FINRA/SIPC. Saratoga Capital Management, LLC, FDX Capital, LLC and EAB Investment Group, LLC are not affiliated with Northern Lights Distributors. The Saratoga Advantage Trust’s Funds are distributed by Northern Lights Distributors, LLC, member FINRA/SIPC. 11/11 © Saratoga Capital Management, LLC; All Rights Reserved.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Fund. This and other information is contained in the Fund’s prospectus, which can be obtained by calling 888.814.8180 and should be read carefully before investing. Additional Fund literature may be obtained by visiting www.SaratogaCap.com or www.JamesAlphaAdvisors.com.

5350-NLD-3/12/2020

THE OPINIONS STATED HEREIN ARE THAT OF THE AUTHOR AND ARE NOT REPRESENTATIVE OF THE COMPANY. NOTHING WRITTEN IN THIS COMMENTARY OR WHITE PAPER SHOULD BE CONSTRUED AS FACT, PREDICTION OF FUTURE PERFORMANCE OR RESULTS, OR A SOLICITATION TO INVEST IN ANY SECURITY.


This information has been prepared solely for informational purposes in connection with one-on one presentation to institutional investors. This presentation may not be reproduced or disseminated without the consent of EAB Investment Group L.L.C.  Past results are not indicative of future performance. Changes in economic conditions will affect the returns of investments in different ways.  Any investment involves a risk of a loss. All information herein is from sources believed to be reliable but have not been independently verified. No representation or warranty can be given with respect to the accuracy or completeness of the information, and is subject to updating, revision, and amendment. EAB Investment Group and its affiliates disclaim any and all liability relating to this information, including without limitation any express or implied representations or warranties for statements contained in, and omissions from, this information.  Prospective subscribers to any service provided by EAB Investment Group should consult their own financial advisors, legal counsel, and accountants as to financial, tax, legal, and related matters concerning their subscription to EAB Investment Group’s service. No part of this presentation constitutes financial, tax, or legal advice.
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. The information in this document is provided solely for general education and information purposes. No statement within this article should be construed as a recommendation to buy or sell a security or futures contract or to provide investment advice. Past performance does not guarantee future results. Supporting documentation for any claims, comparisons, statistics or other technical data in this document is available from EAB Investment Group, LLC upon request.

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