Among other things, Swenson convincingly made the case that:
U.S. Treasury bonds provide a unique form of portfolio diversification, serving as a hedge against financial accidents ... No other asset type comes close to matching the diversifying power created by long-term, non-callable, default-free, full-faith-and-credit obligations of the U.S. government.
In his second book, Unconventional Success,
which was written for individual investors, Swenson provides a sample allocation that includes a 30% weight to fixed income, divided equally between long-term Treasury bonds and Treasury Inflation Protected Securities.
In my view, Swenson’s allocation may make sense to some degree, but I have found that clients view their bond portfolio as the ‘safe’ side of the house and want to leave volatility to the equity allocation.
Many people simply don’t realize just how volatile long-term Treasury bonds can be: in the three years ending February 28, 2010, Vanguard’s Extended Duration Treasury fund (EDV
) had an annualized volatility of 28.85%, which was more than the S&P 500, which had an annualized volatility of 21.89%.
For comparison, the broad based Barclays Aggregate bond index, represented by the Vanguard Total Bond fund (BND
) had annualized volatility of 4.19% - approximately 85% less volatile than EDV.
Still, Swenson makes a good point about the power of long-term Treasury bonds in a portfolio, especially in the face of ‘financial accidents’ like those we experienced during the financial crisis in 2009 and again now with the tragedy in Japan. Judging from the results of EDV over the past few days, Swenson’s argument appears as valid as ever. So (of course!) I decided to do a test.
For the same three year period mentioned above, I looked at three different allocations. I found that adding a small amount of EDV was equally as effective as the whole dollop that Swenson recommends. Of course, this could be a function of the short data set or this particular time frame, but I believe that it is still instructive for investors who want the hedge of long-term Treasury bonds without all of the volatility.
The first allocation, which I titled the ‘Classic 70/30’ is a 70/30 split between the S&P 500 using State Street’s S&P 500 fund (SPY
) as a proxy and the Vanguard Total Bond fund (BND
) as a proxy for the Barclays Aggregate Bond index.
Next, I looked at the Swenson 70/15/15 and replaced BND with EDV for long-term Treasury bonds and the iShares TIPS fund (TIP
) for the inflation-protected securities allocation.
Finally, I use the term ‘Adapted’ to refer to the allocation that reflects my suggestion and includes long-term bonds, but less aggressively. In this case, I used SPY for the 70% stock allocation, BND for the 25% broad bond exposure and EDV for the 5% long-term Treasury bond exposure.
The results indicate that using the long-term Treasury bonds is effective in smaller doses than Swenson suggests, at least over this time period.
It’s interesting to note that including long-term Treasury bonds reduces the volatility of the whole portfolio, despite the high volatility of these securities. This is, of course, related to the negative correlation between long-term Treasury bonds and stocks, which was -0.18 over this period using monthly data. Swenson’s portfolio earned slightly more in returns, but took on an equivalent amount of risk, so the Sharpe ratio is the same.
Today, we have the crisis in Japan, continued sovereign default risks in Europe and unusually high geopolitical risks in the Middle East. Even though long-term Treasury bonds are extremely volatile, I believe that Swenson is correct and a small allocation makes sense as a hedge against these kinds of uncertainties, which are rarely in short supply.
 Swenson, David. Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment. New York: Free Press, 2009. Page 169
 Swenson, David, Unconventional Success: A Fundamental Approach to Personal Investment. New York: Free Press, 2005. Page 34
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Disclaimer: The views expressed do not necessarily represent the views of Acropolis Investment Management, LLC. or its members. Clients of Acropolis own SPY, BND and TIP as core holdings and we are regularly buying and selling both securities for clients as part of our portfolio rebalancing strategy.