Emerging markets activity shows portfolio diversification key to performance

There are times to add risk to a portfolio and there are times to reduce risk, but there is virtually never a bad time for good old-fashioned diversification.
Among all the analysis and concern about rising interest rates, the sluggish pace of economic growth and overextended equity market valuations, there is a chance that the biggest risk that investors and financial advisers are facing is ignoring the basics.
“It is folly to try and game diversification,” said Doug Coté, chief investment strategist at ING U.S. Investment Management.
The most recent example of this was seen in the turmoil last month over the emerging markets. As soon as tapering represented a threat to emerging markets, the selloff began. Almost immediately, market strategists began calling the selloff a buying opportunity.
In fact, over the past 10- and 15-year periods, no broad market stock or bond category has done better on an annualized basis than the emerging markets.
While the emerging markets as a broad category was down 3.3% last year, the category also averaged 12.1% over the past 10 years and 13.3% over the past 15 years.
Only small cap and midcap U.S. equities, which each averaged more than 10% annualized returns over the two periods, came close to the performance of the emerging markets.
From Mr. Coté’s perspective, this speaks volumes about the benefits of diversification by reminding us that in a properly constructed portfolio, it is normal for individual components sometimes to be moving in opposite directions.
“Advisers seem confused about how to invest in these volatile markets,” he added. “Even with the markets up big in 2012 and 2013, there does not appear to be euphoria in the markets, and the ones who are in the market are crowding into U.S. equities, especially large caps. And that can’t be good.”
As Mr. Coté sees it, the emerging markets scare was just the latest example of investors trying to navigate and tweak diversification.
Along those lines, the fear of rising interest rates stands out as exhibit A.
An equally weighted portfolio of 10 broad asset categories that includes large, mid and small-cap domestic equities, global REITs, developed and emerging foreign stocks, U.S. Treasuries, corporate and high-yield bonds, and global bonds would have generated an 11.9% return last year.
That includes a 41.3% return by the S&P SmallCap 600 Index and a 13.9% decline by long-term U.S. Treasuries.
Of the six equity categories, only emerging markets were negative last year and of the four bond categories, only high-yield bonds were positive last year.
Those focused on a rising rate cycle might look at that as a reason or justification to be out of bonds. That’s not the point Mr. Coté is trying to make.
“Diversification means being broadly diversified, and investors are incorrectly fearing rising rates,” he said. “Bonds are primarily for downside protection, not income. I own a lot of bonds for safety so I can own a lot more equities.”
The bottom line is that if you own equities, you are protected against rising rates, and by selling bonds, you missed the primary benefit of owning bonds.
“Rising rates impact only a small portion of the portfolio — long U.S. governments — and they don’t impact credit products such as high yield,” he said. “By not owning bonds, investors are protecting a small part of their portfolio while giving up downside protection.”