In an article last week, I highlighted three investment types where investors typically don't need to layer on additional exposure. Because they play a role in most plain-vanilla portfolios, REITs, emerging markets, and individual large-cap stocks duplicate exposures that most investors had already. Further arguing against these more specialized exposures is the fact that targeted investments frequently cost more than more diversified investment types, and their volatility may spur investors to buy high and sell low.
This week, let's consider the flip side: asset types that tend not to appear in plain-vanilla portfolios. That doesn't mean they will necessarily help diversify a core stock/bond portfolio, however. For example, high-yield bonds infrequently appear in core high-quality bond funds and also have a low performance correlation with the Barclays Aggregate Bond Index, but these bonds' correlation with the equity market is pretty high. Moreover, many of these investment types have fairly high volatility on a stand-alone basis, so if you decide to hold them, it's best to do so in small amounts to avoid jacking up the overall portfolio's volatility.
Here are some investment types that are least likely to pop up in your core stock/bond holdings, as well as an assessment of their benefits on the diversification front.
Overlap Factor: With the exception of a handful of diversified equity funds with gold-bug managers--such as the team at First Eagle Overseas (SGOVX)--gold-mining stocks and gold bullion tend not to show up in many equity-fund portfolios. Total U.S. market index funds stake less than 1% of assets in metals and mining stocks of all types (not just gold miners), and total international stock market indexes have about 2.5% in the mining industry. Just 18 diversified funds in Morningstar's database have more than 10% in miners, and fewer still invest directly in gold bullion. That means a small gold stake, especially bullion, is unlikely to overlap with a plain-vanilla balanced portfolio.
Diversification Factor: The diversification case is there, too, especially for direct ownership of gold bullion. During the past five years, SPDR Gold Shares (GLD) has only a modestly positive correlation with U.S. equities (0.19), a slightly higher correlation with foreign stocks (0.29), and an even lower correlation with a balanced index fund (0.11). (A correlation of 1 means that two assets move in lockstep, while negative 1 indicates that two assets are inversely correlated.) Funds that focus on gold-mining stocks, meanwhile, have a higher correlation with equity funds and are therefore less valuable as diversifiers; for example, Vanguard Precious Metals and Mining (VGPMX), one of the oldest metals equity funds, has a correlation of 0.79 with a total international-stock index fund during the past decade.
That's not to suggest that gold bullion should play a major role in a portfolio, however. A stake of 5% or so is plenty. Indeed, in his most recent analysis of SPDR Gold Shares, Morningstar's Sam Lee argues that gold's most valuable role is as a hedge against currency depreciation, noting that gold is volatile and unlikely to beat equities over time.
Overlap Factor:Like gold, you're unlikely to pick up commodities exposure if you hold a plain-vanilla stock/bond portfolio. Although a handful of prominent all-in-one funds dabble in the asset class-- PIMCO All Asset (PAAIX) and PIMCO All Asset All Authority (PAUIX) come to mind--most do not. Meanwhile, commodities-related stocks will tend to be more duplicative because they are well-represented in broadly diversified equity portfolios. Energy stocks consume about 9% of the global equity market capitalization, for example, while other basic materials firms such as forest-products producers contribute roughly 5% more.
Diversification Factor:Even though commodities exposure (via commodities futures, for example) doesn't appear in many equity-fund portfolios, the diversification case for a broad-basket commodities investment appears less strong than is the case for an investment in gold bullion. During the past 10 years, the oldest diversified commodity fund, Oppenheimer Commodity Strategy Total Return (QRAAX), has had a negative correlation with the U.S. bond market but a higher correlation with the U.S. and foreign stock markets at 0.49 and 0.58, respectively. (Hard-asset producers compose a bigger share of the foreign market cap than they do of the U.S. market, hence the higher correlation with international markets.) Not surprisingly, the diversification case for commodities-related equities is even weaker. For example, T. Rowe Price New Era (PRNEX), the granddaddy of natural-resources funds, has a correlation of 0.79 and 0.84 with the U.S. and foreign stock markets, respectively, during the past decade.
Treasury Inflation-Protected Securities
Overlap Factor: Treasury Inflation-Protected Securities are not part of the Barclays Aggregate Bond Index and pop up only infrequently in most actively managed intermediate-term bond-fund portfolios. ( PIMCO Total Return (PTTAX), for example, has maintained a TIPS stake for much of 2013.) The average intermediate-term bond fund has just 2% of its assets in TIPS. Thus, a dedicated TIPS investment supplies direct inflation protection--something nominal bonds lack--and is also unlikely to be redundant with an investor's core fixed-income portfolio.
Diversification Factor: Although they don't overlap with most core bond funds, TIPS have had a fairly high correlation (0.76) with the Barclays Aggregate Bond Index during the past decade. That's perhaps not surprising when you consider that TIPS, as high-quality bonds, respond to most of the same forces that the high-quality bonds in the index do. Owing to the fact that interest-rate changes, rather than inflation fluctuations, drive so much of the returns on Vanguard's core TIPS fund, Vanguard Inflation-Protected Securities (VIPSX), the fund shop recently launched a short-term TIPS fund. The firm also swapped the short-term fund into its target-date lineup in lieu of the longer-duration Vanguard Inflation-Protected Securities.
Overlap Factor:High-yield bonds make up another category that tends not to appear in most broadly diversified bond funds; most such funds, in fact, are limited by charter in the percentage of lower-quality bonds (those rated BB or below) that they can own. The average intermediate-term bond fund has about 6% in high-yield bonds currently. That means adding a dedicated high-yield component is unlikely to cause significant overlap with core high-quality bond holdings. (If you're interpreting "core" expansively to include a multisector or non-traditional-bond fund, however, you may end up with higher junk-bond exposure.)
Diversification Factor: High-yield bonds tend to have a low correlation with high-quality bonds--for example, the Barclays U.S. Corporate High Yield Index has been only mildly correlated with the Barclays Aggregate Index during the past decade. That said, high-yield bonds' correlation with the equity market is in the neighborhood of 0.75 during the past decade, a relationship that was on full display during the bear market, when high-yield funds lost nearly as much as pure-equity funds. That argues that a dedicated high-yield investment is far from a must-have for investors who already have significant equity exposure. Alternatively, investors who want to hold high yield might do so in lieu of additional equity holdings rather than as part of their bond stakes.
- Basic Materials Industry
- Commodity Markets