How to Play Defense Against the Bears

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Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Stocks have recovered nicely of late, but some investors might be looking at their portfolios wondering if they're in position to play adequate defense for what comes next. Joining me to share some research on that topic is Russ Kinnel. He's director of manager research and editor of Morningstar FundInvestor. Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, you recently did some research where you looked out over the past three bear markets, and you looked at how a total stock market index fund would have performed relative to Vanguard Balanced Index over those three bear markets. What did you find there?

Kinnel: I was simply interested in what kind of defense you'd get from going from a pure equity exposure to balanced. And I found that just using as a proxy, Vanguard Balanced Index versus Vanguard Total Stock Market, and there I found Vanguard Balanced Index had about half the losses from peak to trough as Total Market. This current market wasn't quite as good, about 35% loss for the Total Market versus about a 23% loss for the Balanced Index, which is a 60/40 S&P 500 and aggregate bond index combination. So, significant improvement and diminishment of losses just by going with a plain old 60/40 mix.

Benz: And of course the Balanced Index has a very high-quality, very plain-vanilla fixed-income piece. That helped as well, right?

Kinnel: That's right. That's really crucial in a bear market--at least it has been in the past three, because Treasuries benefit from that flight to quality, whereas a lot of other bond portfolios with maybe a little more credit risk don't hold up as well. Because of course people are worried that those lower-quality credits won't be able to actually make good on their payments.

Benz: You also took a look at a total market index, a U.S. market index, Vanguard Total Market Index, relative to an international index fund. I wouldn't expect that you found that the international index fund held up necessarily relative to the U.S. index. Did it over the three bear markets that you examined?

Kinnel: Not really. You're correct. So in the 2000-02 bear market and the '07-'09 bear market, international did worse. In this current one this year, it did slightly better. But obviously that kind of prompts the question, "Well, what good is international if it's not really going to reduce my losses? Where's the diversification?" And I think particularly in a panic and an extreme sell-off, the markets tend to all go in lock step. And certainly you see that. But where I think the diversification exists is a little more like diversifying between small- and large cap or having healthcare and tech and financials in your portfolio. It's more that there are time periods where the performance can be very different. So, if you look at, say, various 10-year cycles, there are times when international did much better than U.S. and vice versa. I think it's that kind of diversification you're getting. It's not the kind that, say, you get from having Treasuries that are ballast in a bear market, but it's still a meaningful adder of diversification.

Benz: How about value versus growth? Did you see any differential in bear-market performance there?

Kinnel: Yeah. We did see sharp differences between those two camps in that first bear market. As you may recall, 2002, growth got crushed, lost about 51%. And of course, a lot of active growth funds did even worse. Value held up much better, 38% loss. But over the two ones after that, value did much worse than growth. So again, another case for diversification. It's really hard to predict those things, but I think the reason you see those differences is that bear markets tend to hit one or two sectors extremely hard. And therefore, that tends to be either growth or value gets hit harder. And in this current case, of course, it's about being economically sensitive. And those areas, which are in the value camp, got hit hardest. In the 2000 bear market, it was much more about valuation compression because there'd been such a huge speculative boom on the growth side. So you really see there can be very stark differences between value and growth.

Benz: Did you find any category or asset class that performed well and had positive returns in all three bear periods?

Kinnel: Only Treasuries. Long-term Treasuries did particularly well, but even short-term Treasuries did well. Some of the short-term muni indexes and funds had positive returns in the prior two bear markets, but they actually lost money in the current one. Admittedly a small amount, but it makes a lot of sense because there's such a tremendous burden on states in this current environment, as well as tremendous recession that has a lot of people worried about our states, our cities, and other municipal issuers going to be able to make their payments. And so it just shows even high-quality munis are not impervious.

Benz: And high-yield bonds--predictably poor, I would imagine?

Kinnel: Exactly. In eight years out of nine, high yield does so much better than government bonds or even high-quality bonds, because, as the name says, they have high yield, but they do a lot worse in these bear markets--that's the price you pay. In all three of them, we saw high yield losing over 20% from peak to trough. So it's a meaningful hit. And it's just a good reminder to everyone that high yield behaves very much like a hybrid of equities and bonds because they come from equityholders--they come from corporate issuers--but also they come from highly indebted corporate issuers. So in the end, the results of high yields are not so different from that 60/40 Vanguard Balanced Index fund.

Benz: Russ, it's always great to get your insights. I'll look forward to reading the full research in Morningstar FundInvestor. Thank you so much for being here.

Kinnel: You're welcome.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.