Repetition can be comforting at times, as in your morning routine: Shave. Shower. Dress. Try to make it until the coffee kicks in. But repetition can also be frustrating--even frightening, as in the return of volatility to a market that appeared to have taken an extended holiday away from the sort of downside moves that make for unpleasant morning headlines. Nevertheless, higher volatility than we have seen over the past few years is becoming the norm, and as advisors, we should remember that returns are not always positive over the short term. In fact, volatility comes and goes in markets just as high and low returns do. It is especially important, therefore, to incorporate this understanding into your asset allocation. Consider the measurements in Figure 1:
Called the "fear gauge," the VIX Index (VIX is a CBOE ticker symbol) measures the implied future volatility of the S&P 500 Index--a good measure of the expected near-term jumpiness of stocks.
The VIX Index is actually a histogram showing the market's expectation of 30-day volatility with a sequential connecting line. The horizontal bar represents time. The vertical line represents implied volatilities of a wide range of S&P 500 Index options. The volatility was calculated from both calls and puts.
What does this tell you? A quick look at the chart and you can get an instant picture of what happens to volatility. The two spikes in volatility occur during the LTCM and Russia defaults in the 1997/98 time frame and the Enron/dotcom melt down in 2001/2002.
What this means: Volatility and price movements are a fact of any marketplace. Changing news flows, fundamental realities and technical positioning all play a part in moving asset prices over the course of days, months and years. Recently, concerns about the health of the U.S. housing market and its attendant effect on the economy as a whole have erased the YTD gains in stocks globally and have reminded us all that despite our rosy experience in the second half of 2006, prices in all markets can move quickly and, in some cases, painfully.
So how do you guard against large swings in the value of your client portfolios? One way is by introducing--or increasing--the percentage of high-quality fixed-income holdings. As shown in Figure 2, highly rated fixed-income holdings not only have lower volatility, but they also give you a higher return than equities when adjusted for risk over a given time period.
Figure 2 shows a time series (10-year rolling averages through Jan. 6, 2007) of taxable bonds versus equities. The horizontal bar represents different qualities of bonds and stock indices. The left-hand vertical line represents the Sharpe Ratio, while the vertical right represents returns and standard deviation. Sharpe ratio divides the excess return on an asset over cash returns by the price volatility of that asset.
What this tells you: A very high volatility asset with mediocre returns would have a much lower Sharpe ratio than a low volatility asset with very high returns. The Sharpe ratio of stocks or bonds varies significantly depending on what time period is sampled, but a sampling of the last 10 years (using annual samples rolling monthly) provides some interesting results, such as the average annual return, the standard deviation band of annual returns, and the Sharpe ratio of each asset. Higher quality fixed- income assets show lower returns than stocks, but have much lower volatility. As a result, their risk-adjusted return, as measured by their Sharpe ratio, is higher than low-quality bonds or stocks.
What this means: The return of high-quality fixed income, coupled with its relatively low volatility, makes for a powerful addition to your asset class opportunity set.
Figure 3 displays a correlation matrix chart that combines the risk/return profile of high-quality bonds with a negative correlation to equities. Fixed income presents you with periodic income, low volatility/price risk and good diversification potential.
What this tells you: Low-quality, "high- yield" bonds can be appropriate for some situations and can offer some good investment opportunities. However, they have a much higher correlation with equities and a much lower risk-adjusted return than high-quality bonds.
What this means: "High-yield" is not a stand-in for the fixed income portion of your portfolio because it does not have the same negative correlation to equities that high-quality fixed income does.
In general, high-quality bonds will under perform stocks over a long period of time. Therefore, depending on your situation or viewpoint, you may not be able--or even wish--to stick it out through a long period of stock underperformance. The period from 2000 to to2006--despite an extremely strong series of stock returns over the past few years--has seen bonds outperform stocks due to the bear market early in the decade.
This fixed income out-performance is unusual and will no doubt be erased over time by higher trending equity markets, but your investment time frame may be shorter than the three, five, or even 10 years it might take for stocks to regain the upper hand. In addition, because bond funds typically offer a more stable net asset value (NAV), they are more dependable for planning purposes if you have a need for cash in the short to medium term.
Figure 4 shows the performance of the S&P 500 Index over the past 10 years (ending Dec. 31, 2006) versus the performance of a 50/50 combination of the S&P 500 Index and the Lehman Aggregate Bond Index. That 10-year period covers both bull and bear markets for bonds and stocks. Furthermore, it has the benefit of a fairly robust data set as well as being fresh in our minds.
What this tells you: This graph helps you determine which categories yield the biggest gains and which category has the most volatility. Such is the case of the last 10-year period when the S&P by itself returned 8.42 percent annualized, while the 50/50 stock/bond combination returned 7.81 percent.
Does this mean that you're better off in stocks? Maybe not. That extra 0.60 percent in return came at a significant volatility cost.
The S&P 500 had a standard deviation of 17.27 percent whereas the 50/50 combination portfolio had a standard deviation of only 8.07 percent.
Though you made a touch more money investing in long-only stocks, you had a much wider dispersion of returns, resulting at times in an uglier statement. The Sharpe ratio--again, a measure of risk-adjusted return--increased with the combination portfolio to 0.51 from 0.28 with just the S&P 500.
Returns on riskier assets such as stocks will most likely show more volatility in the future than they have over the past few years. If you, as an advisor, have had a favorite bond fund, you might want to re-examine your portfolios to see if you might need the lower volatility and more dependable returns that bond fund may have been providing you.
Most clients think of bonds as an alternative to cash, but appropriate asset allocation will include bonds as a powerful addition in their own right. Bond funds may not be appropriate for every situation, but they certainly make sense as an addition to your list of potential investments.
If you have factored in the downside protection that high- grade bonds can give your portfolio, the return of higher volatility need not be so painful. You can confine the "shave, shower, dress" cycle to your mornings and keep your portfolio from taking a bath.
Jason Brady, CFA, is a managing director of Thornburg and portfolio manager of Thornburg's Limited Term Income and Limited Term U.S. Government Funds as well as co-manager of the Thornburg Investment Income Builder Fund.
