How Do Asset Classes Behave? A Practical Tale

Posted by Carlos Sera on Sep 29, 2015 1:00:00 PM

I named this tale A Practical Tale because after reading it I sincerely hope you gain something practical.  The subtitle is a tribute to one of my favorites–Janis Joplin.  In the lyrics to the song Ball and Chain she sings about how “It’s all the same ___day.”  After reading this tale I hope you learn that when it comes to investing in asset classes what truly matters is your ability to understand and answer this question: How do asset classes behave?  What matters in your pocketbook is your ability to understand the difference between Intra asset class investing and Inter asset class investing.  Intra asset class or investments within the same asset class are for the most par—All the same.  Inter asset class investing or within different asset classes are for the most part—very different.

After reading this tale I also hope you re-recognize the obvious, which is that when it comes to risk, anything other than an investment in cash or bonds is just plain risky.  This includes stocks, real estate, metals, energy, commodities, or just about anything else you want to call an asset class.  In the case of stocks, it doesn’t matter if the stocks you buy are individual ones or come packaged in the form of ETFs, mutual funds or some other vehicle.  They are risky and when they come packaged they are almost all the same when it comes to a key measure of risk which we call the Mar Ratio and we learned about in An Alto Mar Tale.

Much is written about slicing and dicing stocks or stock asset classes, but when it comes to risk, which is how much money you can lose if you invest at the wrong time, what we learn is they are all about the same.  They lose you lots of money during market declines and they all behave about the same.  From a practical perspective this means, if you or your advisor have charted a course into what is called Modern Portfolio Theory or Mean-Variance Optimization then in my opinion the charted course is fraught with risk.  For example, if you examine a typical risky and volatile static asset allocation strategy of the traditional 60% stock and 40% bond mix, you are more than likely going to experience at least a 30% loss in your portfolio at sometime.  I am not saying this is a bad thing.  You may be the type of person that embraces risk because it suits you.  Just be aware.  This means that based on past behavior, no level of stock asset class diversification will save you from losing in excess of 30% during the next 50% decline in global equities.  Why?  The reason why is because there really is no such thing as stock asset class diversification.  Once again, in the words of Janis, “It’s all the same.”  Is there a better solution?  I think the answer is yes but it involves somewhat of a departure from traditional thinking.  For those that are curious you can read Market and Investor Behavior.

In An Alto Mar Tale we presented the Mar Ratio and determined it was a practical ratio that would let us compare one investment to another.  It’s not as simple to understand as Morningstar’s relative ranking system where one fund might get 3 stars and another might get 1 or 5 stars.  However, it does provide meaningful insight that you can’t get from a relative ranking system because the Mar Ratio is absolute.  It is also objective vs. Morningstar’s subjective ranking system.  The Mar Ratio is designed to compare and understand the different behavior of asset classes such as stocks, bonds, commodities, real estate and currencies as well as trading systems and investment strategies.

In this tale I am going to analyze some Vanguard stock and bond mutual funds.  I often use Vanguard mutual funds for analytical purposes because they have a long history, are well known and their index funds act as a proxy to different types of investment options.  They pioneered index funds as passively managed portfolios that would produce approximately the same types of returns as an underlying benchmark.  The following 5 popular mutual funds represent 5 viable stock asset classes.  Let’s look at the following 5 Funds and see if we can garner any useful information.  All figures are calculated based on monthly data and the start date shown in the table through December 31, 2011.


What clearly stands out when analyzing the 5 stock mutual funds above is that at one point over the last 15 years, probably in both the 30 month period ending October 2002 and the 16 month period ending March 2009, these mutual funds lost over 50%.  We can see this by looking at their Max Drawdown.  In each case it is over 50%.  Said differently, if you or your advisor owned all 5 of these funds because you were working under the false hypothesis that stock asset class diversification reduces risk, you now know that stock asset diversification does not reduce risk during market declines.  Let me say once again that these tales are meant to be evergreen or stand the test of time.  I am fairly comfortable saying that as long as humans are making the investment decisions that stock asset class diversification won’t work when it comes to  risk mitigation.  While in theory it works, in practice it doesn’t.  When markets decline precipitously you are simply out of luck.  So our rule becomes the following; investors should treat stock asset classes as though they can’t distinguish one from the other when it comes to risk. 

What else stands out?  We can see that NAESX or investing in US SMALL BLEND was the superior investment because not only did it have the highest CAGR, it also had the second lowest Max Drawdown which produced the highest Mar Ratio.  We can also see that while VIVAX had a lower CAGR than VEIEX, it did it with less risk thus producing a higher Mar Ratio of 0.14 vs. 0.12 and thus was a superior investment.  Lastly, we can see that VGTSX has been a dog no matter how you look at it.

Earlier I spoke about the relative ranking system used by Morningstar.  All 5 of these funds have a star rank of either 3 or 4 with 5 being the maximum according to Morningstar.  We can see how the Mar Ratio ranks the funds and is straight forward.  How does the Mar Ratio compare to the Morningstar rankings?  It comes as no surprise that Morningstar ranked VGTSX a 4 star while only giving VEIEX 3 stars.  This is not meant as criticism of Morningstar.  It is simply to illustrate that while VGTSX might be a 4 star when compared to similar type funds due to its relative ranking approach, when it comes to reward vs. risk it has been a dog and far worse than the other 4 shown.  So before you go off and onlinvest in 4 and 5 star rated funds make sure you know what this means to your portfolio.  Morningstar is a relative ranking system while the Mar Ratio is an absolute ranking system.  Needless to say, when it comes to your money absolute is what matters.  If you invest relatively then you might hear from your advisor or tell yourself the following phrase, “We did very well during the market decline, most people lost over 50% on their money while you only lost 45%.”

One last thought on Morningstar ranking systems as they pertain to stock asset class risk.  I just looked at 5 of their funds that have a current 5 star ratings to see how much their maximum drawdown was during the October 2007 top through the February 2009 bottom.  It came as no surprise that each of the 5 funds peaked in October of 2007 and troughed in February of 2009.  It was almost to the exact day.  This result pretty much kills the case for diversification of stock asset classes since they peak and trough at the same time which makes them highly correlated.  The 5 Funds I examined were ABEMX, ALARX, ARTKX, CCASX and FSCRX.  They respectively lost during the period 53.83%, 50.12%, 47.00%, 42.33% and 45.05%.  Again, this means that no matter how you slice it and even if you own the best stock mutual funds according to Morningstar—stocks are risky and you need to understand the magnitude of their risk.  “It’s all the same.”

While comparing funds in this way provides us with useful information let’s remember that we are not historians.  We can’t invest in the past but only in the future.  I can’t say with certainty that VGTSX, the worst performer in the time frame I measured, will be a worse or better investment than VIGRX or NAESX over the next 5 years, 20 years, etc.  What we can determine however, is the nature of these 5 funds.  We can be fairly certain that unless the period studied was very unusual, all 5 of these funds or asset classes as well as most any stock equity ETF or mutual fund you can purchase will average somewhere between 4% and 10%.  As a generalization, stock funds can be expected to average about 7.5% with a 50% maximum draw down or a Mar Ratio of approximately 0.15.

So the following becomes our first rule for using the Mar Ratio as an investment tool.  TheMar Ratio of stock asset classes will be approximately 0.15 and the reason it is so low is because stocks, regardless of how you classify them, will experience periods of large maximum draw downs.

Let’s analyze 3 Vanguard bond funds now to get a feel for how another asset class behaves.


I try to keep things simple in these tales so I only selected 3 types of bonds to analyze, a short term, intermediate term and long term.  The results show us that since July of 1996 long term bonds have made more money than any of the stock asset classes we analyzed with a CAGR of 8.55%.  This is so outside what one would expect that we will have to dig a bit deeper later in the tale.  Furthermore, the worst monthly drop for long term bonds was 11.90% which is significantly better than any of the 6 stock funds which had drops in excess of 50%.  Amazingly, an investment in short term bonds also made more money than an investment in foreign large stocks.  Short term bonds made 5.02% vs. 4.23% in foreign large blend.  Yet during the worst period for short term bonds the investor only lost 1.88% from peak to trough while in foreign large blend the investors would have lost 58.51%.  Is it any wonder that investors have become disenchanted with stocks and look to bonds to satisfy their portfolio needs.  But beware if you think the high Mar Ratios of the recent past will be the same in the future.  They won’t.  They can’t.  What can we expect to happen?

If you look at the bond fund with the symbol VBMFX what you are looking at is a proxy for the grand daddy of bond funds.  It is the most popular bond benchmark and is based on the Barclays Aggregate Index.  While we can see that over the last 20 plus years the results have been spectacular with returns of 6.87% and a low maximum draw down of 4.99%.  This would be painting a false picture of the actual longer term characteristics of an investment in something such as VBMFX.  The characteristics of VBMFX if we had a longer period to study are very different than what is shown.  The historical returns are more in the 5% category and the maximum draw down is more in the 15% category.  This leads us to a Mar Ratio for intermediate bonds of .33 which I round out to .30.  Short term bonds will have a much higher Mar Ratio while long term bonds will have a lower Mar Ratio.

Lastly, and this should not be misconstrued as investment advice, but with interest rates on the Barclays Aggregate Index currently well below 3%, you can be fairly certain that the 5% historical return is not a reality anytime soon.  We will need rates to rise for historical return opportunities to present themselves again, and the process of rising rates will be very painful for holders of intermediate bonds.  As it pertains to intermediate bonds, I predict pain.  I don’t know when the pain will happen but it will and unfortunately you are making very little in terms of interest for the pain that is on its way.  As I recently heard, “Bonds were investments that offered a return for no risk, now they offer no return for risk.”

The following becomes our second rule for using the Mar Ratio as an investment tool.  TheMar Ratio of the most popular intermediate term bond index will be approximately 0.30 while the Mar Ratio for money market funds is infinite.

That’s it in a nutshell.  Stocks have a Mar Ratio of about 0.15, intermediate bonds are at 0.30 and money market funds or cash have an infinite ratio since they don’t experience losses.  The importance of Mar Ratios can be better understood once you read A Transformative Tale and learn how to transform bond returns into better than stock returns if we assume the same level of risk associated with stocks.

The following table shows what other investments or asset classes performed over different time frames so that you can assess the risk or Mar Ratio of investing in things other than just stocks and bonds.  I find it very useful when looking to add asset classes to portfolios and so should you.  As we know most financial advisors aren’t very knowledgeable and will do whatever their company tells them to do.  Currently they are espousing the virtues of increased asset class diversification under the selling pitch that the reason so many folks lost so much money in the bear market that ended in March of 2009 was due to the fact that they “weren’t diversified enough.”  If your advisor is telling you this myth and you read and understand the following table and my comments then you can tell him Janis says “It’s all the same” and how are we really going to protect ourselves.  The only true diversification during market declines is to not own risk assets or to have a sophisticated and normally very costly hedging program that protects against these catastrophic events.  What is certain is that there is no level or amount of asset class diversification that can help you during trying times so don’t buy into it.  Dig deep and prosper.  Ask for evidence.

All figures are calculated based on monthly data.  The start date is June 1997 and it runs through December 31, 2011.


There is so much to learn from the above but I will just touch on a few points.  If you think you can diversify by asset class through the addition of Real Estate to your portfolio then you would examine the 3 Real Estate funds listed and see what happened to them in terms of how they behaved in the recent bear market ended March 2009.  Guess what—they added zero risk control to your portfolio.  All 3 funds, and they are representative of the majority of publicly traded real estate funds and ETFs had their Maximum Draw Downs on March 2009.  Conclusion—Real Estate adds no risk control to your portfolio.  Let’s examine the Metals, Gold and Energy funds to see if they did better.  These are commonly referred to as commodity investments.  Once again we see they also experienced more than a 50% maximum draw down during the late stages of the bear market.  Conclusion—-Commodity stocks add no risk control to your portfolio.  What does this leave?  If stocks, real estate and commodity stocks are all risky and lose about the same where is an investor to turn?  I hear the siren call of “physical assets.”  Physical Gold actually increased during the recent bear market and is obviously why we currently perceive it as such a great investment.  But will it continue to be?  The answer lies in the nature of gold.  It lost more than 70% of its value the last time it went out of favor so it too has a low Mar Ratio.  I suspect it will behave the same way it did in the past the next time it is out of favor.

Our next tale along with others we have published, A Transformative Tale, will give you some ways to perhaps solve the puzzle associated with the fact that in today’s world, when people panic everything deemed “risky” seems to behave the same way.


Topics: Tales, Volatile Tales