Equity risk and bond risk are analogous to two people standing
next to each other, one shouting (equities), and the other
whispering (bonds). The whisperer is sadly never heard. We draw the
analogy between the volume of their voices and their risk as
defined by standard deviation. There is no balance in this picture
and investing quickly becomes a bipolar experience as investors
ride the often hysterical equity market's ups and downs (economic
expansions and contractions). So what is the solution to this
analogy? There are three: buy the whisperer a microphone, sedate
the shouter, or find another person that can holler just as loud as
the person shouting.
Buy the Whisperer a Microphone
Buying the whisperer a microphone to amplify their voice is
exactly what leverage can do to a financial asset. Take a look at
the risk return plots in Figure 1. If an investor had levered a
bond portfolio four times over the last 18 years, they would have
actually achieved the same risk profile as equities, with a far
superior return. In addition, because bonds and equities have
historically been uncorrelated, the overall portfolio risk doesn't
increase much at all.
Figure 1: The Annualized Return and Risk of Equities and Bonds
(Oct 2003 to Oct 2012)
This solution is really smart in principle, but we wouldn't
recommend it in practice. Firstly, bear in mind the fact that bonds
have been on a multi-decade bull run. Taking the historical return
of any asset class that has done well and levering it provides a
mouthwatering result. Don't, therefore, be too distracted by the
positive outcome. The real problem with this approach is the mirror
image of the return axes and it's called a levered loss.
If bonds and equities decide to correlate, an investor can lose
a lot of money. In 2008 the S&P 500 was down -38% (using ETF
proxy [[SPY]]) and the Barclays Aggregate Bond Index was up 5.9%
(using ETF proxy [[AGG]]). If an investor had levered bonds four
times, instead of losing -20% in a 60/40 portfolio, they would have
lost closer to -10%. But what would have happened if bonds had lost
-10% and the investor had levered them four times? The investor
would have lost close to -40% of their capital. Could it happen?
Probably not, but we don't like making bets with the potential for
large left tails based on "probably not". This solution is too
close to high risk, masquerading as low risk.
Sedate the Shouter
In this solution we directly address the shouter to curb their
overexcited ways; it's the financial equivalent of giving them a
Xanax. This is an approach we do advocate and it is exactly what
lifting the constraint on selling short can do to an asset class.
If you allow managers to both a) buy the securities they like, and
b) sell short the securities they don't like, the resulting risk,
as defined by standard deviation, is radically reduced. Being long
and short at the same time has a dampening effect. Generally, when
the market goes up, the shorts lose money and the longs make money.
When the markets go down, the reverse is true. Using this approach
it is not difficult to reduce the volatility and drawdowns by
approximately one third. In fact, at the extreme end of the
spectrum, in an equity strategy referred to as "market neutral", it
is possible to morph the risk/return characteristics of equities to
look like bonds.
In the traditional paradigm, equity exposure is slowly
eradicated because the need for capital preservation becomes
paramount. That's unfortunate because whilst performance hasn't
been great over the last ten years, generally the equity risk
premium has shown itself to be a powerful return generator over
time. Long/short equity strategies allow the investor to have their
cake and eat it, because they provide capital growth without
compromising capital preservation. Put simply, an investor can keep
a larger allocation of equities for longer by using equity long
Find Another Shouter
The third solution is to find another asset class whose risk is
as loud as equities, thereby challenging its dominance. This is
another approach we advocate and it's what we strive to do through
our asset allocation. The good news is there are a number of
investments in the world that will do this. For example,
commodities are also very volatile but are not highly correlated to
equities over long periods of time. As a result, commodity risk
will push back equity risk. This is best illustrated through the
following simple risk budgeting example:
(click to enlarge)
Figure 2: Dollar vs. Risk Budget, Equities and Commodities (June
2006 to Oct 2012)
We create a simple portfolio with a 60% dollar allocation to the
S&P 500 but switch out bonds for a 40% allocation to DJ UBS
Commodities Index (using ETF proxy DJP). The historical standard
deviation of the portfolio over the last six years was 15%, of
which commodities contributed 45%. Without making any comment about
the returns (which have been similar over that period), we can say
that these two asset classes are evenly matched from a risk
perspective. We have indeed found another shouter, and one with
some interesting and differentiated return characteristics, such as
the potential to perform in an inflationary environment.
The only fly in this ointment is similar to the problem with
applying financial leverage. Correlations are unstable and can
change significantly during periods of stress. Our newly found loud
friends may all start shouting for mercy at the same time, and that
won't really help us.
To conclude, this analogy represents the conundrum most
investors face today. Placing standard deviation central to our
definition of risk, the traditional paradigm of stock and bond
investing appears deeply flawed. It hides a large bet on equity
risk which is in turn a bet on growth.
We would never make the statement that "leverage equals risk".
This is simply not the case and when used prudently leverage can
actually meaningfully reduce risk. However, we are not keen on
giving any of our quietly spoken asset class friends a microphone.
They may turn out to have the voice of an angel (as illustrated in
Figure 1). However, it carries the left tail risk of them using the
microphone to shout obscenities, resulting in the levered loss
Our favored direct solution is sedation; release the long only
constraint and allow managers to short stocks too. Not only will
this reduce equities' contribution to risk, it also reduces overall
risk and allows investors many more years to harvest the important
equity risk premium.
Our favored indirect solution is to find other investments with
equally strong personalities. We used the example of commodities,
but managed futures and publicly traded real estate are two others
that jump to mind. This solution also has one very attractive
characteristic that our analogy does not take into account. In
finance, two hysterical asset classes can actually sum to a more
rational whole. If the asset classes are uncorrelated, they
actually sedate each other! Don't try this at home though, it has
been proven to be a highly unsuccessful strategy in marriage (much
better to be the bond to your partner's equity).
 Using HFRI Equity Hedge Index as a benchmark, it was down
-26.6% in 2008 (source HFR hedgefundresearch.com), when global
equity markets were down in the range of -40% to -50% depending on
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
Next UNG Target $30, If Regulatory And Technical
Hurdles Are Cleared.