By J. Keith Buchanan, CFA, Portfolio Manager, GLOBALT Investments
The underlying theory. Harry Markowitz, known by many as the father of modern portfolio theory, might have been on to something back seventy years ago. He would later become a Nobel Laureate for a lifetime of work understanding and articulating the theory that allocating resources to a combination of equity, bond, and cash exposures is necessary to achieve desired risk and return objectives of an aggregate portfolio.
Correlation is what matters. However, one of his more interesting takeaways was that the average return and average risk of securities is not wholly adequate in constructing efficient portfolios in practice because of one behavioral element that introduces irrational uncertainty. In practice, asset returns are not normally distributed around a mean with differing levels of covariance or risk. Equities and fixed income do not always perfectly balance each other out. In times of economic stress, the correlations between asset classes spike from less correlated to more correlated (meaning they move more-so in the same direction rather than in opposite directions) which, in and of itself, is befuddling. When things get scary, which is when allocators need to be able to rely on negatively or at least less-correlated assets to buffer returns, is exactly when those correlations spike, exposing the portfolio to downside risk rather than the providing the potential protection the allocators thought they had. When a high and immediate level of fear pervades, investors sell everything.
When equities and fixed income aren’t “diversified.” We have seen periods such as this in the past, of course. Over the course of 2018, as the market became fearful that the central banks were making a mistake in pulling back accommodation prematurely, the S&P 500 Index and the iShares 20+ Treasury Bond ETF, two broad market indicators which theoretically reside on opposite ends of the risk/return spectrum, both posted negative returns for the entire year. The most recent episode of pervasive fear was in spring of 2020 when the coronavirus pandemic gripped every aspect of our lives. In that peak moment of fear in March, the S&P 500 Index shed -12.6% in just seven trading days. Over that same time period, the iShares 20+ Treasury Bond ETF shed more than -15%, underperforming equities.
Cash almost always stays uncorrelated. In times of stress, animal spirits overwhelm rational thought processes. People sell what they want at first. Then they sell what they can. It is in those moments where cash delivers its value in spades as a viable component of investor portfolios. When fear is at its highest, cash provides an asset class whose return attributes lack correlation with the rest of global asset prices.
Cash can also be used for duration management. Additionally, as cash is a zero-duration fixed income instrument, we also utilize our cash position in concert with the rest of our fixed income portfolio as a way to pursue duration exposures without changing the weighting or composition of the traditional portion of fixed income as a whole. Approaching our fixed income allocation in this holistic manner affords us the flexibility necessary to remain nimble when market conditions demand.
At GLOBALT, we use cash as an active management tool. With almost no correlation with equity and longer-term debt markets, cash is a valuable and necessary active tool for our team to help our clients achieve their overall portfolio objectives. We do not use cash as a residual catch-all that just builds as we sell assets without good opportunities to buy. Cash offers a unique risk/return combination that we actively “purchase” relative to other less-attractive asset classes. Most importantly, cash’s risk/return profile is most attractive when we see the risk of asset class correlation spikes due to downside shifts that Markowitz warned of two generations ago in his seminal work.
GLOBALT is an SEC Registered Investment Adviser since 1991 and, effective July 10, 2013, remains a Registered Investment Adviser through a separately identifiable division of Synovus Trust N.A., a nationally chartered trust company. This information has been prepared for educational purposes only, as general information and should not be considered a solicitation for the purchase or sale of any security. This does not constitute legal or professional advice, and is not tailored to the investment needs of any specific investor. Registration of an investment adviser does not imply any certain level of skill or training. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information may be required to make informed investment decisions, based on your individual investment objectives and suitability specifications. Investors should seek tailored advice and should understand that statements regarding future prospects of the financial market may not be realized, as past performance does not guarantee and/or is not indicative of future results. Content may not be reproduced, distributed, or transmitted in whole or in part by any means without written permission from GLOBALT. Regarding permission, as well as to receive a copy of GLOBALT’s Form ADV Part 2 and Part 3, contact GLOBALT’s Chief Compliance Officer, 3400 Overton Park Drive, Suite 500, Atlanta GA 30339. You can obtain more information about GLOBALT Investments and its advisers by accessing the Investment Advisor Public Disclosure website.
The opinions and some comments contained herein reflect the judgment of the author, as of the date noted.
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