Morningstar Advisor - June/July 2013 - (Page 38)

Spotlight diversification benefits at the most important time: when equity losses were large. Commodities Commodities are also a broad asset class, covering precious metals, agricultural goods, energy, and industrial metals. Commodities that are not directly used to produce goods and services, such as gold and agricultural goods, have been more effective diversifiers than commodities with cyclicallydriven demand, such as industrial metals. More-cyclical commodities underperformed less-cyclical commodities by 40% in the 2000–2002 bear market and by 30% in the 2007–2009 bear market (Exhibit 2). As with infrastructure, the gains from reducing cyclicality were largest when equity losses were largest. Hedge Funds Hedge-fund strategies differ widely both in terms of the size of their exposure to equities and assets derived from corporate earnings. Some hedge funds maintain a large net-long exposure to equities and corporate debt. Ibbotson, Chen, and Zhu estimated historic equity betas of equity long-short and event-driven offerings to be 0.49 and 0.31, respectively, in their analysis of hedge fund returns from 1995 to 2009.2 Other hedge funds have a more variable market exposure to any asset class and can be long or short. For example, according to Ibbotson, Chen, and Zhu, global-macro funds have a historic equity beta of 0.16. We applied the same analysis to hedge funds and found similar though less-pronounced results. While high-beta strategies actually performed better than lower-beta strategies in the 2000–2002 bear market, they underperformed by 25% in the 2007–2009 market. As the above examples illustrate, the simple approach of holding less-cyclical versions of infrastructure and commodities investments, along with hedge-fund strategies that exhibit low equity beta, would have markedly improved performance of portfolios during the recent large equity downturns. A 10% allocation equally split between less-cyclical infrastructure and commodities and lowequity-beta hedge funds (the same portfolio weights as our earlier example and funded pro rata for a 50% equity/50% bond portfolio) would have added 0.6% annualized to returns while reducing volatility by 0.7% annualized. This result fulfills the aim of diversification: improving the reward for risk, in this case by increasing return and reducing risk. Mind the Valuations Reducing cyclicality and equity beta helps meet the first condition for diversification: adding investments that behave differently from equities and bonds. Achieving the second condition of diversification—avoiding large negative returns—requires a fundamental analysis of valuation and the amount of competition for different strategies. Unfortunately, this is not a simple process, given the lack of publically available information, short track records, and important changes to composition, ownership, and market structure. But the effort is worthwhile. Parabolic rises in asset prices and a flood of money into an asset class or strategy have been leading indicators of subsequent large losses. The worst year on record for hedge-fund returns was 2008, after a spectacular rise of inflows in 2006 and 2007 (Exhibit 3). Investment banks were investing more of their own capital in hedge-fund-like strategies run by internal teams. The amount of leverage that was available went up markedly as equity market volatility fell to very low levels in the mid-2000s. As the total amount of money competing for opportunities increased, the size of spreads in arbitrage strategies shrank, and the prices of assets were generally bid up. Then came 2008, and the withdrawal of capital by investors and debt providers had a big impact on returns. The forced unwinding of positions (long and short) across most hedge funds coincided with losses in most strategies during the fourth quarter of 2008. The impact was made worse by government intervention that banned short selling and led to a chain reaction of portfolio liquidation for arbitrage and hedged strategies. Infrastructure assets enjoyed a similar bout of popularity in the mid-2000s. Utility companies traded at the high end of their historic price/earnings ratios (Exhibit 4). New listed and unlisted infrastructure funds were set up, using increasing amount of debt financing. Transportation and communications assets became a larger part of infrastructure portfolios. From 2007 to 2008, valuation levels reverted to historic norms and then fell to the low end of historic valuation ranges. This de-rating and the inclusion of more-leveraged and -cyclical assets resulted in larger losses during the period than in 2000–2002. Commodities, though harder to value, experienced similar patterns of popularity followed by extreme losses. After the 2000–2002 equity bear market, commodity prices rose to new highs supported by growing demand from China. Commodity indexes proliferated; high-profile pension funds added commodities to their strategic asset allocation; and commodity retail funds and exchange-traded products became available. The underlying cost of supply did rise for many commodities (especially oil, when low-cost supplies were depleted, leaving much-higher-cost oil sources as the only way to meet growing demand). The long history of commodities shows that large price rises trigger changes in demand and supply that force prices back to the long-run cost of supply. When oil peaked at $150 per barrel in 2008 (Exhibit 4), industry 2 Ibbotson, Roger G., Peng Chen, and Kevin X. Zhu, “The ABCs of Hedge Funds: Alphas, Betas, and Costs, Financial Analysts Journal, January/February 2011, vol. 67, no. 1. 38 Morningstar Advisor June/July 2013

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013

Morningstar Advisor - June/July 2013
Contents
Contributors
Letter From the Editor
Not Your Values
How Do You Use Alternatives for Clients?
Working to Build a Niche
How to Put Buffett’s Investing Philosophy into Practice
Sophisticated Strategies for the Masses
Investments á la Carte
Investment Briefs
The Percentile Trap
Defense Firms Will Stay Aloft
Beware the Lure of Diversification
Using Alternatives in Practice
Managed Futures and Cash Rates
The World Is Getting Grayer
Waiting to Pull Up Anchor
The Price of Managing Volatility
Let’s Get Back to Basics
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Mutual Fund Urban Myths

Morningstar Advisor - June/July 2013