Cash, Core and Core-Plus Bond Funds, and Other 'Meh' Diversifiers

Cash was the best-performing holding in many investors' portfolios last year--and in my model portfolios, too. Even as the U.S. stock market dropped 5% and the Bloomberg Barclays U.S. Aggregate Bond Index barely clung to a gain, investors in money market funds and other cash products pocketed yields of as much as 2%. And because cash investments don't lose value, cash investors didn't experience the net asset value shrinkage that many bond investors ran into last year.

But despite its heroic showing in 2018, has cash delivered as a diversifier for stocks over longer time frames? Not as much as Treasury bonds or the Aggregate Index have, based on a follow-up look at data depicting the correlations between stocks and various other asset classes.

Yet an even more surprising finding was that many bond funds that investors use as core fixed-income holdings weren't all that great as equity diversifiers, either. Such funds, which land in the intermediate core bond and intermediate core-plus bond Morningstar Categories, often hold substantial corporate-bond exposure. As a result, their performance has often moved in sympathy with the equity market.

Reading Correlations In an article this week, I assembled asset correlation charts with an eye toward depicting which categories had delivered the best diversification benefit for a plain-vanilla U.S. equity portfolio, as represented by the S&P 500. I included small-cap stocks, foreign stocks, bonds, and a grab-bag of "alternatives" categories, including managed futures, long-short equity, commodities, and precious-metals equities. Over nearly every time period examined, Treasury bonds exhibited the lowest correlation to the S&P 500's performance. From a practical perspective, that means that Treasury bonds tended to perform poorly when stocks were soaring (the better part of the past decade), but they held their ground when stocks fell.

There are intuitive explanations for this contrary performance pattern. Equity-market shocks are often characterized by a "flight to quality," and U.S. Treasuries are typically viewed as a global safe haven. Moreover, serious U.S. equity market downturns sometimes result from extreme weakness in the economy, with the global financial crisis a recent case in point. In such environments, the Federal Reserve often takes steps to drive interest rates down. Because they have no credit risk, Treasuries tend to be direct beneficiaries of such rate adjustments (and feel the pain most acutely when rates go up).

In the latest data run, I decided to add in some additional categories to test their efficacy as diversifiers: cash, as discussed above, as well as Morningstar's newly created intermediate core bond and intermediate core-plus bond categories, as well as funds focused on inflation-protected bonds, utilities, master limited partnerships, and preferred stocks. As was the case with the other data series, I examined the data over various trailing periods, including one-, three-, five-, 10-, and 15 years. These asset correlation charts are available in Morningstar Direct, a software product geared toward professional investors.

To find the correlation between two assets on the charts, find the intersection between them on the horizontal and vertical axes. For example, you can examine the S&P 500's correlation with all of the other asset classes by running down the vertical "1" column. A correlation coefficient of 1 indicates that two assets are perfectly correlated, while a correlation coefficient of negative 1 indicates a perfect inverse relationship. Finally, a correlation coefficient of 0 indicates no correlation at all.

Cash and Other Bonds As noted above, cash wasn't a particularly strong diversifier for U.S. equity exposure, despite its stalwart showing in 2018. While the correlation between stocks and money market funds is lower over the 15-year period than over shorter time frames, over most trailing periods it hovered right around 0.0--an indication of no correlation. Nor would I necessarily have expected there to be a relationship. After all, money market funds maintain stable NAVs; the cash investor's whole return consists of yield. Thus, the only way that money market investments could maintain a consistently negative correlation with stocks would be if money market yields consistently went up when stock prices dropped, and vice versa.

Perhaps more striking than the cash/stock correlation was how much worse intermediate core bond and intermediate core-plus bond funds were as diversifiers for equities relative to more-Treasury-heavy bond indexes. Morningstar introduced the intermediate core bond and intermediate core-plus bond categories at the beginning of May 2019. Funds that previously landed in the intermediate-term bond category are now mapped into one of the two new categories. As Morningstar's director of fixed-income strategies Sarah Bush explains, core bond funds tend to focus on investment-grade U.S. bonds, whereas core-plus bond funds have more latitude to invest in below-investment-grade debt and may also invest in emerging-markets debt and non-U.S.-dollar debt and currencies. Funds in the intermediate core-plus bond category have, not surprisingly, exhibited a higher correlation to the U.S. stock market than those in the intermediate core bond category over all trailing periods, but neither category was especially great at diversifying equity exposure. Treasuries showed much better as diversifiers, as did iShares Core U.S. Aggregate Bond ETF AGG, which, like all Bloomberg Barclays U.S. Aggregate Bond Index trackers, places a heavy emphasis on government bonds.

I also examined a handful of other categories to assess their ability to diversify equity exposure. Inflation-protected bonds, as represented by mutual funds that invest in them, were underwhelming as equity diversifiers. Ditto for funds that invest in utilities and MLPs.

The most effective diversifier of all, based on a negative correlation coefficient with the S&P 500, were bear-market mutual funds. Such funds generally short stocks in an effort to deliver performance that runs counter to the market's. They can rack up strong gains in periods of market tumult, but over more buoyant--or even normal--periods of time, the results can be painful. Over the past decade, for example, the average bear-market fund has experienced annualized losses of 16% per year.

Takeaways Does that mean you should throw your core- or core-plus bond fund overboard? Not necessarily. While venturing beyond government bonds may reduce these funds' ability to diversify, they may be able to make it up on the upside. Over the past decade, for example, core-plus bond funds have handily beaten the Aggregate Index, as well as intermediate-term Treasury funds, by a sizable margin. (Intermediate core bond funds look less compelling, as a group.) It's also important to emphasize that just because an asset type has a positive correlation with another, that doesn't mean its gains or losses will match the other asset type's in magnitude. While many core-plus bond funds posted losses during 2008, for example, those losses were generally in the low- to mid-single digits. The S&P 500, meanwhile, shed 37% of its value.

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