As Economic Conditions Change, So Should Strategies to Help Guard Against Risk

July 2012

Investors traversing the long gap between eras of strong economic growth might feel like a gymnast performing aerial acrobatics on a four-inch-wide balance beam.

In front of Olympic judges, no less.

Historically, diversifying among the three major asset classes of stocks, bonds and cash often provided the necessary balance to keep a portfolio from falling off course. But staying upright in the current topsy-turvy financial environment hasn't been nearly as straightforward.

"The way we think about diversification needs to evolve," says Peter Jacobs, Northern Trust senior product manager for mutual funds. "People used to diversify for different rates of return. But in the current environment, proper diversification requires looking closely at correlations between asset classes."

Indeed, a characteristic of the new environment is the tendency of asset classes that once moved independently to trade more in tandem.

That's not necessarily good — or unusual. Correlations generally increase during periods of financial stress and recede as economic conditions improve.

"Major asset classes are going up and down together," Jacobs says. "When that happens, you don't get the diversification benefit that you had expected."

Jacobs notes that in the 1990s, emerging market equities often traded in the opposite direction of U.S. growth stocks over extended periods. That divergence provided investors with a valuable diversification benefit.

Since then, those two "risk" assets have moved closer to lockstep. The same trend has played out within the U.S. equity market itself.

"Correlations between domestic value and growth stocks, and among small-, mid- and large-cap stocks, are much higher than they used to be," says Jacobs.

The bottom line: Investors can't afford to think of diversification in the same way as during the Great Bull Market of the late 20th century, when moves in one asset class often cushioned moves in another. Bond yields have fallen about as far as they can fall, cash yields are close to zero, and riskier assets face a myriad of headwinds.

"The global economy is more challenged and interconnected today," Jacobs says. "A broader and more sophisticated approach to disarming risk is needed."

The traditional methodology of risk management divides portfolios into two main objectives: growth and income. Equities, of course, might provide the growth while bonds and cash could generate money to help meet living expenses. Together, it was hoped that the two groups would stabilize a portfolio during periods of market stress.

Typically, individual investors established the relative weightings of each group based on their age, financial circumstances, investment goals and risk tolerance. The mix of asset classes — the strategic allocation ratio — remained fixed and was maintained by systematic rebalancing to account for uneven market movements.

Recently, though, many investors have abandoned their ideal strategic ratio. The fear factor has come strongly into play, distorting ratios by propelling a torrent of dollars into fixed-income assets, especially U.S. government bonds.

"A lot of people are overweight in bonds, but they're not getting much income," notes Jacobs. "Plus, they're at risk of price declines if yields rise. (Bond prices move inversely to yields.) So they're not getting paid to take on that risk."

Since the 2008 financial crisis, roughly $1 trillion has fled equity mutual funds for fixed-income, pushing yields on 10-year Treasuries down to the lowest level since 1946.1 At that time, yields were fixed to allow the U.S. government to borrow at unnaturally low rates to pay World War II debts.

Now those artificially low yields are back, the result of ultra-aggressive policy measures by the Federal Reserve — known as financial repression — to prop up a listless economy. Yet at current levels, government bonds and cash equivalents, like money market funds and bank CDs, yield less than inflation.

Meanwhile, the average U.S. stock has nearly doubled since March 2009 despite all the turmoil and uncertainty that's dogged the global economy.2 By some measures, stocks are about as cheap as they've been in a generation — when compared to Treasuries. (See "A Relative Bargain?")

Not that Treasuries haven't done their job, at least so far.

"Treasury bonds have provided their traditional diversification benefit, and we expect that to continue. But what's missing now is yield," says Daniel Phillips, co-portfolio manager of the Northern Global Tactical Asset Allocation Fund. "On a yield basis, investors are losing money on government bonds after inflation. So while Treasuries still could dampen overall volatility, they aren't serving their other primary purpose, which is to generate income that beats inflation."

Risk budgeting
Rather than using only cash and bonds to maintain proper balance, Jacobs and Phillips advise taking a more expansive approach to diversification — one that recognizes that portfolios face additional risks besides recession or slow growth.

Building a portfolio based on the amount of volatility an investor is willing to tolerate is known as risk budgeting.

One tool of risk budgeting is to invest in alternative asset classes — ones that are not as tightly correlated to U.S. stocks. These might include global real estate, emerging market bonds, bank loans, commodities and gold.

Phillips notes that alternative asset classes also could provide some protection against inflation. That's especially important now, since consumer prices could rise sharply when the global economy regains momentum.

"A number of central banks have created massive amounts of money out of thin air," Phillips says. "So inflation could end up being higher than we would expect in such a slow growth environment." Indeed, cash-strapped governments often engineer higher inflation to reduce the real value of their debts.

"They certainly have a powerful incentive to do so again," Phillips says. "Offloading some of your debt burden through inflation is a very tempting policy option."

Notably, Northern Trust views gold as a distinct asset class and deserving of an allocation all its own.

"Many strategists consider gold to be a real asset or commodity, but our research indicates that it actually functions more as an alternative currency," says Phillips, who notes that gold has little in common with pork bellies, orange juice or agricultural farmland. The yellow metal also might offer protection against geopolitical risk, such as that posed by destabilizing nuclear programs in North Korea and Iran.

Preparing for a rainy day
As unexciting as some income-generating assets have become, Phillips strongly cautions against abandoning them altogether.

He expects that Treasuries will continue to provide valuable diversification. Besides, other income-generating asset classes, such as high-yield and investment-grade corporate bonds, have the potential to yield more than inflation and still might offer compelling longer-term opportunities, even if interest rates rise.

There's yet a more basic reason not to discard income assets. Families need to maintain enough liquidity to pay bills and protect against a financial emergency, such as unemployment, a major home or car repair and health care.

"You don't ever want to be forced to sell an asset at a loss because you've run short of cash," Phillips says. "Buy and sell decisions never should be dictated by anything other than the outlook for the investment itself."

Phillips says money market funds and government bonds are ideal for defending against liquidity risk, despite their low current nominal and real yields. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other governmental agency. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund.

Things change
Jacobs cites another aspect of a modernized diversification process — albeit one that requires rigorous research and regular monitoring.

So-called tactical asset allocation tweaks the fixed ratios that characterize strategic asset allocation by a few percentage points in either direction.

The objective of overlaying tactical upon strategic allocation levels is to take account of shifting correlations between asset classes and changes in the outlook for various markets.

Here's an example of how the strategic and tactical can interact.

Northern Trust's Capital Market Assumptions Working Group, comprised of about two-dozen senior investment professionals from its Chicago, New York, Toronto and London offices, recommends a strategic weighting to gold.

The specific allocation was not arrived at frivolously. Committee members spend hundreds of hours analyzing trends projected to hold sway over the global economy for the next five years. Changes to strategic weightings are made annually.

Each month, however, the committee considers small refinements to those strategic allocations. In the case of gold, the weighting was increased recently to reflect the likely impact of still more money printing by central banks.

Though recognizing the importance of broad global equity exposure over the long term, the committee currently prefers U.S. equities over other developed markets due to ongoing turmoil overseas.

"Investors need a long time horizon," Jacobs says. "But they can't ignore nearterm conditions, either." That's because the buy-and-hold approach that once was so profitable has been less effective during the new century.

And it's likely to stay that way, Jacobs believes, until developed market countries solve their debt problems and global growth returns to normal.

Nailing the dismount
In the meantime, investors might take comfort in the potential benefits of a more modern approach to risk management.

"Markets have become highly sophisticated, and the tactics that investors use to diversify their holdings should do the same," Jacobs says. "Risk budgeting can provide investors with the confidence they need to stay the course and not run for cover every time they read a risky headline, which is often these days."

So think of diversification as years of careful training that could keep your nerves in check and help your portfolio stick the landing as the global economy tiptoes and backflips toward what might be better times to come.

It's all about keeping a healthy balance — in life and in your finances.

Equity Risk: Equity securities (stocks) are more volatile and carry more risk than other forms of investments, including investments in high-grade fixed income securities. The net asset value per share of this Fund will fluctuate as the value of the securities in the portfolio changes.

Asset Allocation Risk: An asset allocation strategy does not guarantee any specific result or profit nor protect against a loss.

Interest Rate Risk: Increases in prevailing interest rates will cause fixed income securities, including convertible securities, held by the Fund to decline in value.

International Risk: International investing involves increased risk and volatility.

Money Market Risk: An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other governmental agency. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the Fund.

1 Financial Times. "Bond buyers seeking safety should take heed of history." Burton Malkiel. June 12, 2012. Page 22


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