In a previous post, I showed how different asset classes correlate with one another and their effect on portfolio diversification. Meir Statman, Glenn Klimek professor of finance at Santa Clara University and a member of the Loring Ward Investment Committee, notes1 however, that return gaps between pairs of asset classes may be another way to measure their diversification benefit in a portfolio. Return gaps show the absolute value of the difference in cumulative returns between asset classes over a given time period. This measure considers not only correlation but the standard deviation2 of returns when determining the diversification benefits of an asset class. A look at return gaps against the S&P 500 over the 25-year-period from 1989 demonstrates the diversification benefits of various asset classes, with larger return gaps indicating more diversification benefit.
Short-Term Treasuries appears right at the top of the list; however, one other asset class looks like it would provide some diversification benefit: Gold. Gold also has a large return gap and tends to be uncorrelated with stocks as our previous post showed; why not include Gold in our portfolios?
The table below displays the Sharpe ratios3 for the asset classes over the same 25-year-period. We see that Gold has the lowest Sharpe Ratio of the asset classes examined and does not compensate us as well as other asset classes for the given level of risk. Gold performed particularly poorly from 1990 to 2000, with an annualized return of -3.12%.
Source: Morningstar Direct, May 2014. Past performance is no guarantee of future results. Returns analyzed assumes reinvestment of income and no transaction costs or taxes. This is for illustrative purposes only and not indicative of any investment. Indexes are unmanaged baskets of securities that are not available for direct investment by investors. Index performance does not reflect the expenses associated with the management of an actual portfolio. Refer to table below for asset class representations.
Other asset classes, such as Short-Term Treasuries and Global Fixed Income (hedged to the US Dollar) do a better job of compensating us for the risk, which is why it may be beneficial to include these asset classes in portfolios. In addition, as my last blog showed, Short-Term Treasuries and Global Fixed Income returns tend to have a more consistently negative relationship with stock returns than Gold.
Return gaps provide us another method for evaluating whether asset classes should be considered in portfolios. But when evaluating whether to include an asset class in a portfolio, the risk/return characteristics should also be examined to determine how efficiently you can add diversification to a portfolio.
1Meir Statman, Jonathan Scheid; Correlation, Return Gaps and the Benefits of Diversification; November 2007.
2Standard Deviation depicts how widely the returns have varied over a certain period of time (volatility). Refer to formula at the end of this article.
3Sharpe Ratio is a risk-adjusted measure of return. It is calculated using the standard deviation and excess return to determine the return per unit of risk. Refer to formula at the end of this article.
Please note that the asset classes are represented by the table below.
Stock investing involves risks, including volatility (up and down movement in the value of your assets) and loss of principal. Investors with time horizons of less than five years should consider minimizing or avoiding investing in common stocks.
The risks associated with investing in stocks and overweighting small company and value stocks potentially include increased volatility (up and down movement in the value of your assets) and loss of principal.
Bonds are subject to market and interest rate risk. Bond values will decline as interest rates rise, issuer’s creditworthiness declines, and are subject to availability and changes in price.
Real estate securities funds are subject to changes in economic conditions, credit risk and interest rate fluctuations.
International markets involve additional risks, including, but not limited to, currency fluctuation, political instability, foreign taxes, and different methods of accounting and financial reporting. As a result, they may not be suitable investment options for everyone.
The price of gold may be affected by global gold supply and demand, currency exchange rates and interest rates. Investors should be aware that there is no assurance that gold will maintain its long-term value in terms of purchasing power in the future.
Treasuries are backed by the US government and are subject to interest rate and inflation risk. Treasury values will decline as interest rates rise. The value of the U.S. dollar depreciates over time with inflation, so the primary risk is inflation risk.