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Timely Charts

A picture is worth a thousand words ---- except that sometimes pictures can be misleading! In the "Chart Essays" section we present small nuggets of analysis based on charts or "pictures".

Key concept: diversification across asset classes.

Chart Essay #4: March 2009

Cross Asset Diversification

Or, How Diversification Might Have Helped You!

In our articles on Equity Risk and Diversification (see menu item “Timely Topics”), we focused on equity risks.  We found that while the adverse market experience of 2008 and early 2009 was extremely negative, it was generally not outside the bounds of expectations based on history.  Moreover, since the downturn was essentially a global equity event it could not have been “diversified away” by equity investing alone.  In other words, investing across global equity markets could not have provided any significant risk reduction relative to equity exposure in individual equity markets.

However diversification in a broader sense, diversification across asset classes, would have helped investors weather the storm.  In particular, investing a significant portion of a portfolio in bonds would have both lowered risk over all periods, and over the long run it would have enhanced return as well.   We show this with a simple example, comparing an equity-only portfolio with a bond-equity portfolio. As in our other Chart Essays we take the point of view of a Canadian investor.  

Canadian investors who suffered very severely in 2008 likely had most if not all of their assets in equities, and we will represent this case using an ETF-based portfolio.  Since most Canadians still concentrate a high percentage of their assets in Canada, the equity portfolio has 60% invested in the Canadian SP/TSX60 Index (XIU ETF), with the remainder split equally between the U.S. S&P500 and EAFE (Europe, Asia, and Far East). To mirror the fact that most investors would have obtained the non-Canadian exposure using mutual funds, which would have had unhedged(1) foreign currency exposure, these positions will be held in the U.S.-based IVV (S&P500) and EFA (EAFE) ETF’s with their returns translated into Canadian dollars.

Our alternative bond-equity portfolio has 50% in the equity ETF portfolio as described and 50% in the Canadian Universe bond index ETF, the XBB.  Each portfolio is rebalanced back to the allocated weights on a quarterly basis.  Figure 1 shows the historical cumulative returns for the two examples.


In 2008, the year most people focus on, the equity portfolio fell -28.93%, slightly better than the -31.13% of the XIU (Canadian SPTSX60 ETF) on its own.  The bond-equity portfolio fell -12.25%, a painful but much more manageable loss.  But investors should not just focus on 2008, since the benefits accrued over the whole history of this example. 

As the year-by-year results show in Table 1, the bond-equity portfolio outperformed when equities were falling or only slightly positive, and the equity-only portfolio outperformed when equities were rising strongly.  As Figure 1 and the summary results in Table 1 both show, the Equity-Bond portfolio outperformed cumulatively to the end of 2007 (5.87% versus 4.39% annualized), and outperformed by an even larger amount when 2008 is included (3.68% versus 0.01% annualized). 

Table 1:
Annual Returns to Strategies
(Rebalanced Quarterly)
  3 Equity ETF's Unhedged Bond-Equity Mix Unhedged
2000 1.47% 6.11%
2001 -13.48% -2.63%
2002 -16.53% -4.01%
2003 19.12% 12.94%
2004 10.92% 9.07%
2005 17.52% 11.73%
2006 19.83% 11.77%
2007 3.40% 3.42%
2008 -28.99% -12.25%
Summary Statistics
    3 Equity ETF's Unhedged Bond-Equity Mix Unhedged
Ann. Return to 2007 4.39% 5.87%
Ann. Return including 2008 0.01% 3.68%
Ann. Risk (Std. Deviation) 14.08% 7.31%


Just as importantly, the bond-equity portfolio exhibited roughly half the risk  (standard deviation) of the equity-only portfolio:  7.31% versus 14.08%.  So the historical fact is that the bond-equity portfolio outperformed the equity-only portfolio at much lower levels of risk.

The main point of this Chart Essay is to show the historical fact of the benefits of historical cross-asset diversification over the 2000-2008 period. For those investors who do not have ready access to benchmark information, it gives a basis for comparison with your own investment portfolio results, and shows what could have been achieved with a very simple and low-cost strategy.. 

It is important to realize that the success of this cross-asset diversification historically does not imply that the success will be continued in the future, and should not be taken to imply that we endorse a continuation of the simple strategy moving forward. While the risk-reducing properties of a large allocation to bonds can be expected to continue, the strong return profile may not.(2)


(1)  See Chart Essays #1 and #2 which discuss some of the implications of unhedged versus hedged currency exposure of foreign assets. (Return to text)

(2) To give a quick perspective on this, at the end of 1999 the Canadian 10-year government bond yielded 6.25%, while Canadian equities had a dividend yield of 1.39%. Even taking into account expected inflation, the expected return versus risk of bonds was very attractive relative to equities. At the end of March 2009 Canadian 10-year bonds yielded 2.79%, while the SP/TSX 60 had a dividend yield of 3.58%. With an expectation that inflation will again return after the current downturn, the expected return after inflation for bonds is very low. As of April 2009, investors who want diversification outside of equities may be looking in other directions, such as real return bonds, short-term bonds, and corporate bonds.  

Structured Capital presents a book by Tim Appelt:

How do you get THERE from HERE?
Learning and Playing the Long-term Investment Game

frontcoverHistorical analysis of long-term global equity and bond returns is used to develop an analytical framework for a historical attribution of returns. In turn this attribution approach is used to develop expectations of future returns that acknowledge the past but take into account current market conditions.

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