Beyond Cash, Stock, Bond Diversification

Paul Justice: Thank you for joining me. I'm Paul Justice, director of ETF research, North America, for Morningstar.

Today, I'm reporting live from the ETF Invest Conference, and I'm joined by Sandip Bhagat, who is a principal of the Vanguard Group and the head of equities.

Sandip, thank you for joining me.

Sandip Bhagat: It's a pleasure to be here, Paul.

Justice: I would really like to get some ideas from you about building a core portfolio. The principal concept of stocks and bonds are enough for a portfolio. Do you support that viewpoint or do you think that there is more that people can bring into the mix to really give a better investor experience?

Bhagat: The stock, bond, cash framework is a useful starting point. Look, it's hard to get excited about cash right now with the yields close to zero. But we have seen what an important buffer it can be when equity volatility picks up and stock prices decline dramatically.

I would point out, however, that the inclusion of bonds and cash, while they reduce portfolio volatility, do come at the expense of returns. Equities provide a risk premium compensation for bearing risk, and you cut into that as you reduce portfolio volatility.

So as a thought, going forward, I might point out that positions in alternatives, alternative risk premia, where you do bear risk, get compensated through returns, but in a way that is different than equities, streams of returns that are somewhat less correlated with equities. That might be another way to diversify your portfolio beyond the traditional asset classes.

And the benefit of this approach, if done properly, is that you get the diversification perhaps without giving up as much of the return.

Justice: I think that most folks do strive to have those non-correlated assets that will generate some sort of positive risk-adjusted return. There are many choices that are available to people. How many can folks realistically put into the context of their portfolio, and just generally speaking, what types of funds might those be?

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Bhagat: We're still talking of a broadly diversified fund that does look for exposure across multiple asset classes. Eventually, how much of a position you take in these alternative return streams is a function of the risk tolerance and the investor's own risk aversion. But an allocation in the 5%, 10%, 15%, 20% range would not be unusual.

I would point out, however, that these strategies thus far have come bundled to investors in somewhat undesirable configurations. They've tended to be opaque, illiquid, expensive, and so that is something to keep an eye on that as you pursue a position in these types of asset classes, make sure that they are understandable, sufficiently liquid, and not onerously expensive.

Justice: And I would say, never buy something that you don't really understand, no matter what the back-tested statistics will really say about that.

Bhagat: Absolutely. Because, look, you and I have been around long enough to know that it's hard to come across the back test that doesn't look good, right.

Justice: Right.

Bhagat: Because what does get shown is something that did work in the past. So that's a very useful caveat. I might even state it somewhat more strongly. If you don't understand in the first two minutes, it's OK to tune out.

Justice: I agree with that. But when we start bringing in these--we're talking about that strategic portfolio. If I start bringing in alternatives and maybe rotating through those, does that really take me away from my strategic asset allocation and make me a tactical asset allocator? Is there a difference or is there a gray line in between the two?

Bhagat: We spoke about the breadth of positions, right? What could be included? This is giving us what we call cross-sectional diversification. The question you posed is about time horizons. How long should you hold these diversified positions? Should you revisit them once a week, once a quarter, once a year, or is strategic asset allocation still alive, planned over long time horizons?

And I would submit that as tempted as we are to swing back and forth and get out of a falling stock market and then get right back in, that temptation could well be an illusion because it is so hard to get that right.

So what I would recommend is, diversify across as many different risk exposures as possible and not to suggest that you just leave this in place for 10, 15 years and walk away, that it is this purely static position. But do revisit it.

Valuations are a powerful driver of future returns. And in fact, when we talk about the lost decade for equities, you know what, Paul? That decade was lost even before it began, simply because of valuations, but calibrated over long horizons. We were looking at P, prices, relative to 10-year average earnings.

So go ahead and look at these types of drivers to fine tune your risk, your return, your correlation expectations, periodically. There is no fixed recipe; I can't tell you that once a year is more appropriate than twice a year. But with some periodicity, revisit this because your needs for return, your funding needs, your liabilities could well have changed. Market conditions change. So there is this balance between trying to do it on a daily or weekly basis versus not doing anything for 10 years.

Justice: So really the statement shouldn't be buy and hold. It should be buy, hold, reassess, rebalance, and that still makes you a strategic investor, and it set yourself up for a good investor experience over a long time horizon.

Bhagat: Absolutely. Especially, if you have given yourself the exposure to many different sources of returns, not fads, not pursuing what we call "alpha" or just active management. But if there are true risk premia, exposures to risk that you expect will get compensated over the long haul, that should be a well-behaved, well-balanced portfolio.

Justice: Well, I'm glad that you seem to agree that buy and hold is not dead and will likely never die. So, Sandip, thank you for joining me. And thank you to all of you for joining us. Please check back to Morningstar.com and our ETF Solution Center for more information on other ETF topics and coverage of our ETF conference.