Global Stocks and Bonds

All the assumptions and data used for the balanced portfolio to this point reflect a 100 percent domestic portfolio. Equities used the S&P 500 Index as a proxy. Obviously Treasuries and TIPS are both U.S.-based. Commodities are global assets, although most are denominated in U.S. dollars. Thus, the balanced portfolio could be much more diversified by simply expanding outside of U.S. markets.

Incorporating global equities (those from countries outside of the United States) and fixed income securities into the mix could improve the overall return-to-risk ratio over time. This is because instead of being dependent on the U.S. economic environment alone, you are able to spread the risk across multiple economies across the globe. U.S. stocks may be performing poorly, but stocks in Japan may be doing fine because Japan's economic growth may be stronger. Going global applies to fixed income assets as well, including non-U.S. inflation-linked bonds, which were actually created long before TIPS were introduced in the United States in 1997. Exposure to multiple countries and economies simply spreads the risk without giving away much upside.

Global diversification is one of the easiest diversification enhancements that can be made to the balanced portfolio structure that I have presented because global equities and fixed income securities generally share the same economic characteristics as I have described for the U.S. asset classes. Global stocks are biased to outperform during rising growth and falling inflation environments just like U.S. stocks. The difference is that a global equity portfolio consists of exposures to several countries, each of which is biased toward its own economic conditions (although global economic conditions may ultimately impact cross-border companies due to international ties).

The one difference between a global portfolio and one that is domestically based is the potential volatility. Non-U.S. equities may be more volatile relative to U.S. equities due to increased risks from currency fluctuations, politics, and so on. Emerging markets equities are usually more volatile than U.S. stocks because the aforementioned risks are generally perceived to be even higher in these regions (even though the balance sheets of many of these countries are currently superior to those in the developed world, including that of the U.S.). The bottom line is that their economic bias is similar to that of U.S. stocks, but their slightly higher volatility should be noted when determining how to weight asset classes.

Equity Subsets

Stocks, being a popular asset class, come in a variety of sizes and flavors. I just discussed expanding equities to include non-U.S. regions. You also have the option of selecting a subset of this broad market. For instance, equities can be subdivided into growth or value, and into large or small capitalization. Although these segments do experience diverging returns over time and different levels of volatility, their general economic bias to growth and inflation are similar to the equities that I have already described. This connection is reasonable since broad groups of public companies, whether they are large or small, generate profits similarly. Likewise, growth companies and cheap value companies by and large earn money similarly when profits are considered within the context of broad economic themes.

You may break down equities further into categories that are more directly linked to either growth or inflation factors. For example, you may be able to find a basket of stocks that are more hedged against rising inflation than the average public corporation. Perhaps companies that can consistently raise their dividends may provide superior inflation protection than the broad stock market can. Moreover, there may be certain industries that are better able to pass through cost increases to their customers and that therefore are less sensitive to inflation. Likewise, some types of companies seem to withstand weak economic environments better than others.

All of these distinctions within the stock market may be valid, but they may only make a difference at the margins. If you do find an equity subsegment that you are confident can withstand (and better yet, appreciate during) inflation and weak economic periods in the future, then you are free to plug it into your portfolio. You just need to make sure you account for it correctly when determining its economic bias and volatility.

Also, recognize that the analysis goes both ways. If you decide to only hold stocks that are biased to perform better during weak economic periods, during rising inflationary times, or both, then you leave yourself exposed to the opposite environment: If the economy is very strong, then your stocks may not keep up with the market. More importantly, the gains may be insufficient to make up for the underperformance elsewhere in your balanced portfolio. Again, the key is to ensure that you have balanced it appropriately and that comes from categorizing it correctly at the beginning.

Since we are still talking about stocks, the volatility of these subsets will be roughly similar to that of the overall stock market. However, the slightly higher risk of smaller companies should be noted. This segment includes riskier business ventures because the companies are often less mature than larger capitalization stocks (i.e., small businesses trying to become large companies). Growth and value stocks, on the other hand, have not experienced markedly divergent volatilities through time, particularly as compared to bonds, TIPS, commodities, and other asset classes. Some research may suggest different levels of volatility, but many of those findings are highly dependent on the time period observed and results may vary depending on the starting and ending points used in the analysis.

Corporate Bonds

Another variety of bonds, outside of Treasuries (or sovereign debt of other countries), includes corporate bonds. As their name indicates, these bonds are issued by corporations rather than by governments and therefore are not backed by the full faith and credit of the government. Due to the greater risk of default, or credit risk, these bonds typically offer a higher yield than Treasuries. This asset class also contains a wide range of credit ratings. There are companies that are rated AAA, meaning that their debt is considered very safe. Consequently, these bonds have a lower yield to reflect their relative safety. Companies rated BB and below are viewed as high yield, or junk, bonds because of the higher yield they offer and the greater risk of default.

The excess yield above Treasuries that corporate bonds offer is termed the credit spread, which is the difference between the yield of corporate bonds and that of Treasuries (the risk-free rate). In general, the greater the odds of default, the higher the credit spread. The credit spread is effectively the excess return that investors receive for taking risk (minus the expected default rate of these bonds). This is the same concept that I've covered throughout this book when comparing the expected returns of each asset class to the returns offered by risk-free cash. Treasuries are used here instead of cash in order to match the duration of the bonds and simplify the math.

The critical observation to appreciate is the material difference between Treasuries and corporate bonds in terms of their economic bias. Treasuries, as you know, are biased to outperform during falling growth (and falling inflationary) periods. Corporate bonds benefit from rising growth as opposed to falling growth. Like Treasuries they are biased to do better during falling inflationary outcomes; however, unlike Treasuries, they can get absolutely crushed if inflation falls too much and nears deflationary levels. You will notice that even though corporate bonds are structured like Treasuries, they actually share the same economic biases as equities. Although they are technically bonds, they act more like stocks.

The way to understand and figure out these biases on your own is to appreciate the factors that ultimately lead to improved conditions for the asset class. Corporate bonds generally yield more than Treasuries, but do so because the risk of default is higher. Thus, it is reasonable that these bonds will perform better as the odds of default decline. Based on this core understanding of what drives the returns of the asset class, you can take the next step in the logical sequence. Stronger economic growth makes it more likely that the company will not default because its profits are biased to improve (just as is the case when thinking about the economic bias of stocks). Moreover, falling inflation is a plus because it lowers input and borrowing costs, further improving profit margins. This is exactly the same rationale for the economic bias of equities. You should then understand why deflation is so bad for corporate bonds. In a deflationary environment the economy has collapsed and corporate earnings have likely plummeted. Treasuries fare well during this environment because they do not have credit risk, while the credit of corporations (or at least the perceived creditworthiness) takes a catastrophic hit. Finally, corporate bonds also benefit from falling inflation because of the increased prospects for falling interest rates. The fixed coupon of corporate bonds, like Treasuries, becomes more attractive with falling rates.

The volatility of corporate bonds lies somewhere between that of stocks and similar-duration Treasuries. This should make sense: Corporate bonds can be considered a hybrid investment because they share characteristics of both equities and Treasuries. Like equities, corporate bonds are issued by public companies. When public companies do well, both the stocks and bonds of that issuer benefit, and vice versa. Similarly to Treasuries, corporate bonds are debt instruments, and the upside (if held to maturity) is limited to a return of the original principal plus the coupon. Consequently, the volatility of corporate bonds can be approximately categorized as medium, or somewhere along the spectrum between low-risk intermediate dated bonds and high-risk stocks. Of course, high yield bonds typically come with even higher volatility, as they tend to be even more sensitive to economic shifts.

Emerging Market Bonds

Similarly to corporate bonds, debt issued by emerging markets offers a higher yield than U.S. Treasuries. This spread can vary significantly by emerging country because of variations in credit, political, social, currency, and other risks that exist among countries. One way to think about emerging market bonds is they lie somewhere between Treasuries and U.S. corporate bonds. Similarly to Treasuries, these are sovereign fixed-income securities backed by the emerging economy's government. Like corporate bonds, these securities are not as safe as Treasuries and therefore offer a yield spread above Treasuries.

In order to determine the appropriate economic bias some understanding of these economies and how they generally differ from developed nations is required. Many of these developing countries are able to expand their economies by taking advantage of demand that comes from outside their borders. By definition, these are economies that are in an early phase of their maturation periods and that are working toward becoming fully developed, self-dependent countries. Thus, much of their growth comes from selling abroad rather than to domestic consumers. Goods, services, and commodities are produced in emerging markets and exported to richer nations. Therefore, the growth and inflation dynamics that support these factors tend to benefit emerging markets, which consequently creates upward pressure on emerging market bond prices.

Emerging market bonds are biased to do better during periods characterized by rising growth and rising inflation. Stronger growth is a positive outcome because that normally leads to more purchases of the goods, services, and commodities that these countries are trying to sell. Improved overall profits make it more likely that the government will make good on its promise to repay its debt (the bonds in which you have invested).

Rising inflation is also a benefit because the items that are being sold—the goods, services, and commodities—cost more. The higher revenues that come from selling these items results in greater profits, which ultimately improves the probability of the country paying off its debts.

Due to their beneficial economic bias (which is similar to commodities), emerging market bonds can be an interesting asset class to include in your balanced portfolio. The inflationary component may be particularly useful given the lack of available inflation hedges.

The volatility of this asset class tends to fall in line with that of corporate bonds. This is because these two areas generally share similar characteristics due to the existence of credit risk. Note that emerging market bonds, depending on the specific structure used, may contain currency risk as well. Oftentimes, the volatility that comes from changes in the currency may be even greater than the volatility of the underlying bond in local currency terms. When analyzing the volatility to use for this asset class in your balanced portfolio framework, make sure to first understand the extent of the currency factor impact in your investment and adjust your volatility estimates accordingly.

Municipal Bonds

Municipal bonds are debt obligations issued by states and local government entities. Investors who pay taxes generally purchase these securities because municipal bonds are usually tax-free investments. That is, the interest rate paid on these bonds is typically exempt from federal and state taxes (under certain conditions).

This unique asset class tends to share characteristics with Treasuries, although lower rated bonds can act more like corporate bonds. Higher quality municipal bonds—those with strong credit ratings—are similar to Treasuries. These bonds are considered relatively safe because they are backed by entities that have historically exhibited fairly low default rates. In fact, municipal bonds normally offer even lower yields than Treasuries because of their tax advantage (note that Treasuries are federally taxable). High quality municipal bonds are widely considered a more tax-efficient version of the risk free asset and therefore have the propensity to outperform during falling growth and falling inflation environments (like Treasuries). Their volatility is also similar to that of Treasuries (both of which largely depend on the duration of the bond).

Lower quality municipal bonds, however, can act more like corporate bonds. They tend to offer a higher yield because of the increased credit risk. Consequently, lower quality municipal bonds are biased to outperform during rising growth and falling inflation climates like corporate bonds. Moreover, like corporate bonds, these lower quality issues also tend to be a little more volatile than higher quality municipal bonds.

Commercial Real Estate

Commercial real estate comes in two main forms: public and private. Real estate investment trusts (REITs) are publicly traded companies that are in the business of managing real estate. The vast majority of their profits, which come from operating commercial real estate, must be passed on to their shareholders. This asset class provides investors with the opportunity to invest in commercial real estate while maintaining liquidity. The drawback is similar to that of commodity stocks. You not only gain exposure to the underlying investments (real estate in this case) but also to the management of the company. Thus, your returns are impacted both by general shifts in real estate prices as well as broad changes in stock prices. Private real estate, on the other hand, involves a direct investment in commercial buildings such as offices, industrial buildings, retail space, and apartments. This approach involves a more direct link to commercial real estate prices but does not offer the liquidity advantage of public REITs.

The environmental bias of commercial real estate in terms of economic growth should be fairly intuitive. Rising growth is a positive outcome because it results in increased rents as stronger economic growth supports incomes and corporate profits. Higher incomes make household tenants in apartments more likely to absorb higher rents. Improved corporate profits enable businesses to afford more expensive leases for office, industrial, and retail commercial space. Moreover, better overall economic conditions lead to greater demand for commercial real estate properties, which produces upward pressure on prices.

The inflationary bias of real estate is a bit more difficult to discern. Most people believe that real estate is an inflation hedge because it is a real asset. You can touch the land and the building, and as overall prices rise real estate is worth more. This is particularly true because of the relatively limited supply of commercial real estate and the long lead time required to develop new properties. These observations are accurate and support the conclusion that real estate commonly reacts positively to inflationary conditions. However, there is a competing force that makes real estate outperform during falling inflationary climates. Real estate is commonly acquired using some leverage, as most real estate transactions are not 100 percent cash purchases. Falling inflation generally leads to lower interest rates, which effectively makes real estate more affordable. Conversely, rising inflation often corresponds with higher interest rates, creating a headwind for real estate affordability. All else being equal, it costs more to buy real estate as the rate of interest climbs. Higher financing costs also negatively impact your net profit in real estate, as one of the biggest expenses is the cost of interest on your mortgage. In addition, real estate's bias toward shifts in inflation is largely dependent on the terms of the deal made between the owner and the tenants. The rent paid may be fixed or variable. The leases may be short-term or long-term. In other words, there are many variables that impact the sensitivity of commercial real estate to shifts in inflation, so the net results are mixed. That is, real estate is neither a rising inflation nor falling inflation asset, as these countervailing forces may roughly offset each other over time.

The volatility of commercial real estate can be tricky to ascertain. The volatility of REITs, which is similar to that of equities, is easier to calculate because REITs are public companies. Private real estate does not price daily because it is an illiquid asset. Even if you appraised the properties each day, the value is unlikely to shift materially over shorter time frames. Therefore, the volatility can only be estimated. Given this limitation, a medium level of volatility seems appropriate. It should be less than that of public REITs, which trade daily and involve equity as well as real estate risk. Like a bond that pays a steady stream of income, private real estate does experience less volatility than many other asset classes. Even though the income from private real estate may be relatively stable over time, the price of the real estate does change. Combining these factors, categorizing it as a medium-volatility asset class seems to be reasonable. Of course, if your real estate is highly levered or has below average liquidity, then the volatility may be higher.

Private Equity

Private equity is very similar to public equity (the category that I have spent a considerable amount of time covering). The only difference is that it is privately held as opposed to publicly traded. Both are investments in the equity of companies. Private equity is not marked to market or priced daily as are public stocks. Some investors categorize private equity as an alternative investment, suggesting that it is a completely different type of asset class. The reality is that public and private equity are quite similar in terms of their behavior, even though you may not see it day to day (because the price of private equity does not reflect changes in conditions on a shorter-term basis).

This asset class is quite simple to categorize: It is a rising growth, falling inflation asset, just like public equities. This is a long-term assessment since the price is typically only updated a few times a year. Notwithstanding the illiquid nature of private equity, the underlying fundamentals of the companies represented are impacted by shifting growth and inflation conditions, just as are public companies.

Similarly to private commercial real estate strategies, private equity does not offer daily pricing. In fact, this asset class is typically even less liquid than real estate. That said, the underlying volatility of private equity is essentially the same as that of public equities, if not greater. From a pure measurement standpoint, since private equity does not price often, the volatility of the returns may appear low. However, this is more of a measurement shortfall; the true risk is at least as great as it is for public companies. Many experts compare the risk of private equity to that of small capitalization public stocks, which tend to experience higher volatility than larger companies. I share this caveat to point out that you shouldn't take the low calculated volatility figure and plug it into your balanced portfolio process.

Hedge Funds

Hedge funds represent a wide array of investment strategies. The term hedge fund merely refers to the structure of these funds, just as mutual funds or exchange traded funds refer to different investment structures. The actual investments that can be found inside hedge funds vary greatly. That said, the vast majority of hedge funds tend to be overweight equity risk. This is basically because hedge funds, generally speaking, invest in stocks and bonds. They also typically employ some leverage and most are able to short various markets. Certainly there are exceptions, but hedge funds as a broad group tend to have a similar environmental bias as equities (just like 60/40 portfolios). The equity risk is much higher than that of bonds and therefore it tends to drive overall results.

Consequently, the general economic bias of this broad asset class is rising growth and falling inflation. Since this is an area in which extreme diversity exists, it can be difficult to reach general conclusions. Thus, you should analyze each strategy separately to determine its particular bias. Perhaps you can observe how a particular hedge fund has reacted in the past to shifts in economic growth and inflation (which may be difficult since many of these funds have not been around very long). You may also dig deeper to understand its primary holdings.

Since there are so many different types of hedge funds, there is no way to generalize the volatility of this asset class. Part of your analysis when considering hedge funds is to identify the expected volatility in addition to the economic bias as described above.