3 Ways to Diversify Equity Risk

Given the stock market’s rocky performance last year and the volatility we’ve experienced during the past several weeks this year, investors may be thinking more about risk than they have in the recent past. Specifically, some may be looking for ballast for their equity positions.

Last week, Morningstar director of personal finance Christine Benz took a fresh look at Morningstar's asset class correlation data, in an effort to find the best ways to diversify equity risk. She found that plain-vanilla, high-quality bonds have been the best diversifiers for equity-heavy portfolios during the past decade.

“Of course, a relationship that has held in the past--high-quality bonds zigging while stocks are zagging--may not hold up in the future,” noted Benz. That’s because correlations are based on past performance--and that performance may not repeat itself in the future if the market environment changes. “Yet, historic correlations, while imperfect, are the most reliable gauge we have when aiming to build diversified portfolios,” she admits.

With that in mind, today we’re sharing some of our analysts’ favorite picks across a trio of high-quality taxable bond categories that would do a fine job of diversifying an equity-heavy portfolio.

Long-Term Government Funds Long-term U.S. Treasuries offered the greatest diversification value vis-a-vis stocks during the past decade, as measured by the Bloomberg Barclay's U.S. Treasury 20+ Year Index and the S&P 500.

Investing in such long, sterling-quality fare comes with its own set of risks, of course. Notably, U.S. Treasuries are extremely interest-rate-sensitive, making them poor choices if one expects any significant upward movement in the long end of the yield curve. To wit: The average fund in the long-term government Morningstar Category skidded more than 13% in 2013 as the yield curve steepened and the market feared that the Federal Reserve would stop its quantitative easing program.

For those who, despite the risks, want to add such high-quality, long-duration fare to their portfolios, a trio of long-government exchange-traded funds earn Morningstar Analyst Ratings of Bronze. iShares 7-10 Year Treasury Bond ETF IEF offers low-cost exposure to U.S. Treasuries with seven to 10 years until maturity. Siblings iShares 10-20 Year Treasury Bond ETF TLH and iShares 20+ Year Treasury Bond ETF TLT track longer-duration indexes.

Long-Term Bond Funds Funds in this category also ply the long end of the yield curve, but they don't cling exclusively to U.S. government fare. As such, this group of funds is generally a bit less interest-rate-sensitive than the long-term government category.

Here, Silver-rated Vanguard Long-Term Bond Index VBLTX and Vanguard Long-Term Investment-Grade VWESX are standouts. The former is passively managed and tracks the Bloomberg Barclays U.S. Long Government/Credit Float Adjusted Index. It currently has about half of its assets in U.S. government bonds with the balance in high-quality corporates; it carries a duration of 14.86 years. The latter is actively managed (by subadvisor Wellington Management) and tucks about three fourths of its assets in high-quality corporate bonds. Its duration stands at 13.61 years.

PIMCO Long Duration Total Return PLRIX also earns a Fund Analyst Rating of Silver. Management uses a combination of macroeconomic forecasting and bottom-up analysis when constructing the portfolio, about two thirds of which is tucked in corporate bonds today. Duration clocks in at 13.88 years.

Intermediate-Term Government Funds Benz notes that in the past, she'd focused on long-term Treasuries when running Treasury/equity correlations; this year, she added the shorter-duration Bloomberg Barclays 5-10 Year Index to the mix. What did she find?

“Somewhat surprising (to me) was that the short- and intermediate-term index provided nearly as much diversification as the long-term index. That's good news, because long-term Treasuries can be really volatile; short- and intermediate-term bonds, while not invulnerable to interest-rate changes, tend to be more placid and easier to own,” she says.

Indeed, while the long-term government category lost nearly 14% in 2013, the intermediate-term government category shed less than 3%.

A dozen funds in this category earn Morningstar Fund Analyst Ratings of Bronze or better.

Several of the funds in the group stick exclusively with Treasuries, including iShares 3-7 Year Treasury Bond ETF IEI (Bronze), Vanguard Intermediate-Term Treasury ETF VGIT (Silver) and iShares US Treasury Bond ETF GOVT (Bronze).

Others favor mortgage-backed securities, such as iShares MBS ETF MBB (Silver), Vanguard Mortgage-Backed Securities ETF VMBS (Silver), BlackRock GNMA BGPCX (Bronze), Fidelity GNMA FGMNX (Gold), and Vanguard GNMA VFIIX (Gold). Like Treasury-focused funds, these portfolios are high-quality, but mortgage-backed securities tend to offer higher yields than Treasuries to compensate for their prepayment risk (which is more likely when rates decline.) Moreover, only GNMAs carry the legal backing of the U.S. government.

And still others blend Treasuries and mortgage-backed securities, including PIMCO GNMA and Government Securities PDMIX (Silver), Fidelity Government Income FGOVX (Bronze), American Funds US Government Securities AMUSX (Bronze), and JPMorgan Government Bond HLGAX (Silver).

Premium Members can access a complete list of Morningstar Medalist Funds here