Monday, December 12, 2011

Most Misunderstood Asset Class Today?

Yves Lamoureux sent me this Business Insider article, The Most Misunderstood Asset Class Today:

Richard Bernstein,, the former Chief Investment Strategist of Merrill Lynch, is out with his 2012 outlook, which includes his five favorite investment themes. One of those themes: "Positions in treasuries to maintain portfolio diversification."

He expands on this asset class:

Perhaps the most misunderstood asset class today is US treasuries. It is unfortunate that some politicians in the US have attempted to tarnish the potential creditworthiness of treasuries and have scared many investors because treasuries continue to behave as the world’s highest quality asset class. As we have emphasized for many years, treasuries are the only major asset class that currently provides diversification to a multi-asset portfolio. In fact, long-term treasuries (as measured by the BofA Merrill Lynch 15+ Year US Treasury Index) returned over 25% and 30-year zero-coupon treasuries returned over 60% from June to September this year when most other asset classes decreased in value.

Chart 12 shows the correlation between the S&P 500 and a broad sample of asset classes. The reality is that treasuries, regardless of maturity, are the only asset class that today has a negative correlation to equities. Virtually every other asset class is positively correlated. This means that a portfolio that contains five or ten asset classes, but does not contain treasuries, is probably not a diversified portfolio.

Bernstein reiterates that Treasuries are used for diversification, not income.

It is also unfortunate that investors have been put off by treasuries’ low yields. Treasuries always have low relative yields (remember that bonds are priced by basis points “over” treasuries). Income-oriented investors can always find superior yielding bonds. Today’s situation is nothing new.

One reason why Treasuries are attractive right now is because their duration is relatively high. To clarify further, when bond duration is high, small moves in interest rates lead to relatively large moves in price. Bernstein expands:

Treasuries’ lower yields have actually increased their diversification potential. As yields fall, treasuries’ duration increases (they become more interest rate sensitive). Thus, smaller amounts of treasuries can be used to diversify portfolios without losing effectiveness.

And when Treasury prices fall...

What if rates go up? In that situation, treasuries would likely underperform. However, most other asset classes would probably appreciate in that economic backdrop, and their outperformance would likely more than offset the negative return in treasuries. We find it somewhat startling that investors are willing to invest in assets that are traditionally quite risky like gold, commodities, hedge funds, or private equity, but they refuse to invest in treasuries, which continue to show safe-haven properties.

Yves wrote a comment recently on why the last true diversifier left is not gold:

I have always loved hard assets and financial stocks and bonds. I always maintain an equal amount of both with a view to potential performance. I find the debate surrounding inflation/deflation issues fascinating, as both commodities and financials have gone up together. In fact, both groups have been right in the price direction.

I also have been correct in holding both sides of the equation: we recommended both bonds and grains last summer.

This is where it gets interesting. Can the deflation and inflation camp both be wrong at the same time?

If all assets are positively correlated now, how do you truly hedge those bets? I have consistently offered my opinion to use treasury bonds as the way to reduce risk. The hard reality now is that mathematically the leverage of a 30-year bond needs to be amplified or increased in quantity to offset weakening investments.

For a long time bonds have acted as an offset to portfolios. They showed a negative correlation. I am of the belief with outstanding issues that bonds will revert to a positive correlation to other financial assets. If this was to pass they would not offer any value in diversification. They would not offer you any compensation in overall risk management.

Gold is a great credit risk hedge. I have written numerous articles that showed at key times the complete disbelief in the metal. Be aware that gold is showing the same correlation to stocks and commodities. In effect, you are not trying to increase the proportion of investments going the same way but rather the opposite way.

So, for us the ultimate hedge used in our portfolios will become the mighty US dollar. Trust that I am grinning as I write the word mighty.

Agree with Yves, beware of gold and stay long USD. But while the euro fell to the lowest level in two months versus the dollar, I also believe all the gloom and doom is way overdone. I do not see the euro collapsing -- it is pretty much range-bound for a long time. I'd be buying euros at or below these levels and selling them each time EUR/USD approaches 1.40.

But let me get back to Bernstein's comment above. I agree with him too, it's quite puzzling that that investors are willing to invest in assets that are traditionally quite risky like gold, commodities, hedge funds, or private equity, but they refuse to invest in Treasuries, which continue to show safe-haven properties. I wrote a comment last July on why Treasuries are the last diversifier left, and flat out stated: a low interest rate environment, asset classes tend to be a lot more correlated than investors think. With so much pension money flowing into hedge funds, real estate, private equity, commodities, and infrastructure, this should worry us.

Indeed, all this money flowing into "alternative investments" is positive for Treasuries. This is something which very few asset allocators understand, which is why I'm not surprised to see that the strengthening U.S. economy is proving no deterrent to the biggest rally in Treasuries since 2008.

But all these flows into alternatives are also going to create more speculative bubbles along the way, which is why I'm ignoring the doom & gloom from Europe and positioning myself for another melt-up. Speaking of melt-ups, the world's most famous investor is betting big on solar (h/t, Ari T). Top hedge funds are also betting big on solar. With solar now hitting grid parity, it will be one of the most promising sectors of the future.

But for now, all eyes remain on Europe as money managers prove to me once more that they are all sheep who herd together when the going gets tough and don't deserve a dime in fees they're charging clients. They can't seem to focus on the bigger picture and will get caught with their pants down as they obsess over Eurotrash.

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