Strategic Eye Candy

Strategic investment perspective is essential, but it doesn’t grow on trees. If you’re looking for context beyond the usual suspects, you’ll have to dig deeper. The good news is that there are lots of opportunities for mining strategic intelligence. Too many, perhaps. One of the biggest challenges in developing intuition about portfolio design and management is deciding where to cut off the analysis and start making actual investment decisions.

It’s not obvious where to begin either, but here are a few possibilities. Let’s start with Sharpe ratio, a risk measure that compares excess returns over the risk-free rate with return volatility. Higher Sharpe ratios equate with superior risk-adjusted return. Imagine two securities, each with the same annualized historical return—10%, for instance. But one security posts a 15% annualized standard deviation (volatility) and the other weighs in at 20%. The Sharpe ratio for the first security (0.66) is higher than the second (0.5). The difference implies that the first security delivered a higher return per unit of risk, i.e., a higher risk-adjusted return.

Sharpe ratios are only one risk measure in a sea of atlernatives and so this metric should only be considered in context with additional analysis. But every thousand-mile journey must begin with the first step and Sharpe ratios are a worthy launch of any investment expedition. With that in mind, consider how rolling 3-year Sharpe ratios for U.S. stocks (S&P 500), REITs (MSCI REIT), U.S. bonds (Barclays Aggregate Bond), and commodities (Dow Jones-UBS Commodity) compare since the late-1990s, as shown in the chart below.

Sharpe ratios obviously aren’t written in stone. Risk-adjusted performance fluctuates, sometimes by more than a little in a short period. Unfortunately, the fluctuation can be random, but only partly. High Sharpe ratios tend to give way to lesser readings, and vice versa. Timing is always unknown, but the cyclical aspect is intriguing and perhaps useful to a degree. On that note, bonds generally post relatively high Sharpe ratios vs. stocks, REITs and commodities these days. That profile more or less reverses the state of affairs for Sharpe ratios in the days before the Great Recession and financial crisis of 2008.

Next up is rolling 3-year correlations between U.S. stocks and REITs, bonds and commodities. Correlation of return is a measure of performance independence. Two return series with a 1.0 reading are said to have perfect positive correlation. In effect, they’re indistinguishable, and therefore of no value for portfolio diversification. At the opposite extreme is a -1.0 reading, or perfect negative correlation. That is, one security moves in the exact opposite direction at all times vs. another. In the middle is a zero correlation, which equates with totally random behavior between two securities.

The obvious trend in the correlation chart above is that there’s a fair amount of change through the years. Indeed, correlations between U.S. stocks and the other three asset classes have risen in recent years. But within that broader trend it’s also true that the correlation between stocks and bonds is trending down. Is something comparable on tap for stock/commodity and stock/REIT correlations?

The third chart below compares rolling 3-year annualized total returns. Lots of volatility here too, albeit with the exception of bonds. Unsurprisingly, investment-grade fixed income is a relatively tame asset class. That doesn’t mean you can’t lose money in bonds, but the short-term whipsaws are likely to be less of a roller coaster ride vs. stocks, REITs and commodities.

What can you do with the strategic information in the charts above? One possibility is using the trends to identify productive periods for rebalancing a multi-asset class portfolio. In late-2002 and early 2003, for instance, the Sharpe ratio on U.S. bonds was soaring as the Sharpe ratio on U.S. stocks was crashing. As it turned out, that was a ripe moment for rebalancing.

That brings up the observation that bond Sharpe ratios have been relatively elevated lately while the equivalent for U.S. stocks, REITs and commodities are somewhat depressed. Hmmm….

About James Picerno 894 Articles

James Picerno is a financial journalist who has been writing about finance and investment theory for more than twenty years. He writes for trade magazines read by financial professionals and financial advisers.

Over the years, he’s written for the Wall Street Journal, Barron’s, Bloomberg, Dow Jones, Reuters.

Visit: The Capital Spectator

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