Perspectives | A Diversification Check-Up

October 2019

Past Performance Is Not Indicative...?

Historically the monthly stock market return has been positive about 65% of the time.¹ Recently, however, a false sense of security has washed over investors. The S&P 500 has delivered a positive return in 81% of months over the past three years including multiple stretches of four or more consecutive months of positive returns.¹ The lull of a slow and steady stock market allows people to forget about the benefits of diversification – and perhaps more dangerously – mistake holding different asset classes as being “diversified.” 

Well Everyone Else is Doing It

The go-to bond investment for diversification is often an “Agg” or core bond fund that tracks the Bloomberg Barclays US Aggregate Bond Index (remember when saying the ‘Lehman Agg’ was much easier?). This has been the core standard for bond investing focused on US Treasuries, mortgages, and high-quality corporate bonds. But the bond market has changed dramatically over time. Gone are the late 1980s and early 1990s when a core bond fund delivered an 8-9% yield.²

Fast forward three decades and today investors are lucky to get a 2.5% yield (before inflation!) and significant duration (interest rate sensitivity) risk.3 A bond duration of 1 (years) generally means that if rates rise 1%, bond prices will decline 1%. Right now, the typical core bond fund has a duration of around 6 years and a yield of less than 3%. That means if rates were to rise just 1% from current levels the index would experience a roughly 3% loss or greater.³

This lower yield and higher interest-rate risk combination poses a problem as rates sit at historical lows and will likely rise over time, yet core bonds are often used as the primary or even sole bond exposure for retirees, pre-retirees and some target-date fund offerings. If you’re confident the future will mirror the past you have nothing to worry about. For the rest, it appears prudent to expand the non-equity allocation to include core-plus and multi-sector fixed income offerings. These strategies may better combat an unknown future interest rate environment and better manage fixed income risks without giving up the asset class ability to diversify equity exposure. 

Market Metrics

During the third quarter of 2019 many broad asset classes flip-flopped between positive and negative returns each month. The S&P 500 Index gained 1.7% while the small-cap Russell 2000 Index declined 2%. Trade war fears continued to spook investors as did signs of slowing global growth. Non-US equities were negative in the first two months but did rebound during September. Major bond indices were also positive for the quarter, thanks to a decline in interest rates in August. The 10-year declined from 2% to 1.5% during the first two months, settling at 1.7% to close out the quarter.⁴

Index Calendar Year Returns 2008-2019

 Printable version

 1 Monthly total return of the S&P 500 from January 1998 to September 2019. Calculations by Mesirow Financial.
2 12 month yield of Vanguard Total Bond Market Index (VBMFX). The Vanguard Total Bond Market Index is designed to provide broad exposure to U.S. investment grade bonds.
3 12 month yield and average effective duration of Vanguard Total Bond Market Index (VBMFX).
4 Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; https:// fred.stlouisfed.org/series/DGS10.
Sources: 
Index return data and valuations from Morningstar 
Important Information:
The S&P 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies.
The Russell 2000 Index measures the performance of approximately 2,000 small-cap American companies.
The MSCI EAFE Index is designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada.
The MSCI Emerging Markets Index measures equity market performance in global emerging markets.
The Bloomberg Barclay’s US Agragate Bond Index is a broad base bond market index representing intermediate terminvestment grade bonds traded in the United States.
The Bloomberg Barclay’s US Corporate High Yield Index is composed of fixed-rate, publicly issued, non-investment grade debt.
The Bloomberg Barclay’s US Treasury 10-20 Year Index is a market-capitalization weighted index that measures the performance of public obligations of the U.S Treasury that have a remaining maturity of ten to twenty years.The indicies are unmanaged and does not incur management fees, transaction costs or other expenses associated with investable products. It is not possible to directly invest in an index. 
Past performance is not indicative of future results. The views expressed above are as of the date given, may change as market or other conditions change, and may differ from views express by other MF associates. This is not a solicitation to buy or sell the securities mentioned. Do not use this information as the sole basis for investment decisions, it is not intended as advice designed to meet the particular needs of an individual investor.
Information herein has been obtained from sources which Mesirow Financial believes to be reliable, we do not guarantee its accuracy and such information may be incomplete and/or condensed. All opinions and estimates included herein are subject to change without notice. This communication may contain privileged and/or confidential information. It is intended solely for the use of the addressee. If you are not the intended recipient, you are strictly prohibited from disclosing, copying, distributing or using any of the information. If you receive this communication in error, please contact the sender immediately and destroy the material in its entirety, whether electronic or hard copy. This material is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.