Professor Craig Israelsen of Brigham Young University is emerging as an important voice in the asset allocation debate. The reason? He keeps things simple.
In a November/December 2007 article in the Journal of Indexes ("The Benefits Of Low Correlation"), Israelsen examined the performance of a simple portfolio built with combinations of up to seven different asset classes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities.
His conclusion? Only REITs and commodities added a major diversification benefit, and they deserve to be included in all portfolios ... including conservative retirement portfolios.
He recently spoke with the editors of HardAssetsInvestor.com about his seven-part portfolio.
HardAssetsInvestor.com (HAI): What did your study on correlations show?
Craig Israelsen (Israelsen): Basically that diversification really works. That's a real stunner, isn't it?
HAI: Shocking. But seriously, how did it work?
Israelsen: I built equal-weighted portfolios out of up to seven different asset classes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities.
For commodities, I used the S&P GSCI commodities index going back to 1970. I'd note that before 2001 or 2000, the GSCI was not investable, so I'm making the assumption that there could have been an actual portfolio tracking that index back in 1970.
In my original analysis, I started with an equally weighted two-asset class portfolio composed of large-cap and small-cap U.S. stocks, and I looked at the returns. Then I started adding more asset classes: non-U.S. stocks, bonds, cash, REITs and commodities. I found that as you added the additional asset classes, you improved the returns and limited the worst one-year drawdown of the total portfolio. But importantly, it was not a linear relationship.
HAI: How so?
Israelsen: There's a major change when you get to commodities and REITs.
With the five-asset portfolio - large-cap U.S. stocks, small-cap U.S. stocks, non-U.S. stocks, bonds and cash - which is about what the typical target date portfolio held three years ago, you get a 10% internal rate of return while sustaining retirement withdrawals. The worst one-year drawdown since 1970 is 17%.
When you add REITs and commodities, the internal rate of return rises to 11.3%, which is nice. But the worst one-year drawdown falls to 10%. That's a 40% reduction!
Most people wouldn't immediately notice a 1.3% increase in the annual return. But they would notice a 40% reduction in the worst one-year drawdown. You can feel that.
HAI: Why does that happen?
Israelsen: Commodities and real estate have fairly low correlations to the core assets of large-cap U.S. stocks, small-cap U.S stocks and developed markets international equities.
When people buy foreign stocks, they think they are diversified. But the three main equity asset classes have correlations of 0.7 to 0.9. You don't get a lot of correlation benefit from adding more equities to an equity portfolio.
Cash is a good diversifier, and so are bonds. But they don't have a very attractive long-term return. The real benefit comes when you add REITs and commodities. They have equity-like returns, but low correlations ... and in one important way, they have lower risk than equities.
HAI: Lower risk for commodities?
Israelsen: In a way.
I've recently updated the data on this study. Between 1970 and 2006, large-cap U.S. equities had about an 11% return. But there were eight years in that 37-year period where large-cap stocks had a negative return. Moreover, the worst 3-year cumulative return was about 38%, from 2000-2002.
Over that same time period, commodities had an average annual return of 11.5%. They had nine years with a loss, so one more than large-cap U.S. stocks. But the worst 3-year return for commodities was only 26% - much better than equities.
I think that surprises people. It runs up again the idea of commodities being risky investments.
Another important factor is timing. Take foreign stocks. The worst 3-year drawdown for non-U.S. stocks was 43%. That drawdown came at the same time as the worst 3-year drawdown for large-cap U.S. stocks: 2000-2002. When you have two assets that both have their worst 3-year periods at the same time, that's not helpful.
By contrast, the worst 3-year period for commodities was 1996-1998. That offset was helpful for portfolios.
Raw correlation is only a starting point. Most people use it as a starting and ending point. You really have to look at year-to-year returns and look at the patterns of major upside moves and major downside moved. If they don't overlap, I'm willing to be less worried about high correlations. If the correlations are high and the worst-case periods occur at the same time, that's not good.
HAI: What do you hope people take away from your study?
Israelsen: That retirement portfolio may be improved by being a little bit more exotic.
One of the things people have objected to about my seven-asset class portfolio is that it has a pretty high commitment to so-called alternative assets. It sounds pretty iffy. But over this 37-year period, the worst 3-year return for large-cap U.S. stocks was bigger than the worst 3-year return for commodities. So which is more risky?
Commodities live with a stigma that they are incredibly volatile. I think that's because people look at short time periods. I haven't studied it, but I think commodities may have more upside and downside moves over short time frames, but when you measure them annually, I would make the argument that commodities have demonstrated lower volatility than large-cap U.S. stocks.
I think what happens in equities is that you get momentum that stays. If you have a bad year in equities, you might have another bad year after that. But with commodities, it can turn around more quickly. The year after the worst 1-year drawdown in commodities, for instance, commodities returned 41%.
Volatility is often measured by standard deviation, and on that measure, commodities do poorly: They have a standard deviation of 24% versus 17% for large-cap U.S. stocks.
But standard deviation is more a mathematical concept than a useful investment figure. I would argue that the worst 1-year return or worst 3-year drawdown is a more compelling statistic. Most investors would have no idea how to calculate standard deviation, or what it means. But they all know what a drawdown feels like.
If you look at other measures of risk besides standard deviation, commodities aren't as radical as we want to believe.
