Arnott: The Long View—Building The 3-D Shelter

October 26, 2011

There may never be a better time to build a 'third pillar' to existing developed world equity and bond allocations in your portfolio.

 

The word hurricane is derived from “juracán,” a Spanish derivation of a word from the indigenous islanders of the West Indies. The islanders believed in a god named Juracán that either was the storm or created the great storms that descended upon them certain times of the year.1 Given the ferocity and resulting disruption of daily life, Juracán and his storms not surprisingly helped define the islanders’ culture. Columbus learned of the word shortly upon arriving in the New World and brought the term back to Spain for its eventual incorporation into most Western languages.

A half-millennium later, we use the term to describe the “3-D” storm that will likely be at the forefront of capital markets. Unending deficits, massive debt, and unfavorable demographics, like low pressure eddies over warm ocean waters, are the kinds of conditions that create stagflationary squalls over the next decade or more. With recent markets focused relentlessly on the presumed deflationary impact of a double-dip recession and European contagion, the market is focused on—to borrow a phrase from Will Rogers—a return of capital, not on capital. But for the vast majority of investors, the relevant time horizon is much longer and likely to be inflationary. Sadly, traditional portfolios are likely to leave many investors caught up in the storm surge of rising prices.

In this issue, we will suggest gradually building a “third pillar” to existing developed world equity and bond allocations. Such a portfolio should produce more meaningful real returns over a market cycle—an outcome we assert should be the ultimate goal for investors.

A Miss For Diversification And Real Return Assets

Before we delve further into the prognosis for inflation and portfolio implications, let us review the recent asset allocation environment. Table 1 shows third quarter performance of the 16 asset classes we typically use to proxy a more diversified portfolio than the traditional 60/40 equity/fixed-income standard asset allocation.

 

201110_Fundamentals_Table1.jpg

 

The diversified portfolio fell 6.2%, the bulk of which occurred in the quarter’s final month. September, with its –4.5% return, was the eighth worst month since 1988 for the diversified portfolio. In fact, the diversified 16 asset class mix also trailed the traditional 60/40 blend of S&P 500 Index stocks and BarCap Aggregate bonds, which posted a –3.9% return.

Since 1988, such shortfalls for diversification have largely been associated with crisis periods where massive uncertainty forces investors to first sell alternative markets, where perhaps risk is least understood. Parenthetically, there’s probably some “maverick risk” contributing as well—large losses in emerging market local currency bonds draw far more scrutiny than similar declines incurred in the S&P 500! As Figure 1 shows, the September loss for the 16-asset portfolio was exceeded only in four noteworthy periods—the 2008 Global Financial Crisis, the 1998 Long-Term Capital Management/Russian Default, the 1990 Invasion of Kuwait, and the September 2001 terrorist attacks. Interestingly, these previous crisis periods all subsequently witnessed superior results—an average of 2.7% per annum over the 60/40 portfolio—in the three years post crisis, as shown in Figure 2.

 

 

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