THE REWARDS OF MULTI-ASSET CLASS INVESTING

INVESTING INSIGHTS THE REWARDS OF MULTI-ASSET CLASS INVESTING Market volatility and asset class correlations have been on the rise in recent years, leading many investors to wonder if diversification still works. Our research finds that building portfolios using multiple asset classes with dissimilar patterns of returns is a strategy that stands the test of time. The concept of wealth diversification is at least as ancient as the 2,000- year- old Talmud1. But it wasn t until modern times that academics like Harry Markowitz, considered the father of modern portfolio theory ( MPT ), statistically demonstrated the risk-return benefits to an investment portfolio of combining assets with low or negative correlations. In the 1950s, Markowitz, a Nobel Prize winner in Economics, showed mathematically how MPT can be used to maximize portfolio expected return for a given amount of portfolio risk, or to minimize risk for a given level of expected return. Several decades later, in 1998, financial adviser Roger Gibson published a landmark paper entitled Asset Allocation and the Rewards of Multiple-Asset-Class Investing. A pioneer in strategic asset allocation, he showed how combining four volatile asset classes with dissimilar patterns of return generated a portfolio with a higher return and dramatically less volatility than a weighted average of the returns and volatilities of the four component asset classes. The paper Gibson assigned equal allocations to each of the four asset classes and studied the period from January 1, 1972-December 31, 1997. Since then, much has happened in financial markets, including two stock market crashes and rising cross-asset-class correlations. This paper revisits and extends the research to study the same multi-asset class portfolios performance for the 40 years stretching from August 1, 1972-July 31, 2012 (with quarterly rebalancing) to see if the original conclusion still holds. How Does Diversification Work? Before going into our findings, let s briefly define four terms that are basic to understanding the concept of portfolio diversification. Return: This is the amount an investor earns on an investment. For instance, a 4% return on $100 investment is $4. Risk: Here, we re referring to the extent of price swings, or volatility, of a security over an investment time period. For example, if a $100 stock swings between $80 and $120 in the course of a year, we consider it riskier, or more volatile, than another $100 stock that fluctuates between values of $85 and $115 during the same time period. Risk may also be quantified as standard deviation, which measures this swing: the higher the standard deviation, the more volatile the asset price. Correlation: Correlation is a statistical measure of the extent to which, and the direction in which, the prices of multiple assets move in relation to each other.mathematically, correlations range from -1 (perfect negative correlation, where assets move by equal magnitude in opposite directions) to +1 (perfect correlation, where assets move by equal magnitude in the same direction), with 0 correlation signifying no relationship among the assets price movements. Ideally, we want to add assets to a portfolio that behave differently from the existing portfolio elements, since low (or better yet, negative) correlating assets enhance diversification and reduce volatility. Knowledge of the historical correlations between securities is vital to selecting securities that can potentially maximize a portfolio s risk-adjusted return. Efficient Frontier: A portfolio that minimizes volatility for a given expected return, or maximizes expected return for a given level of volatility, is considered efficient. Efficient portfolios make efficient use of risk. Combining the various efficient portfolios for a given group of asset classes results 1 The Talmud states: Let every man divide his money in three parts, and invest a third in land, a third in business, and a third let him keep in reserve. Investment Products & Services Not insured by FDIC or any Federal Government Agency May Lose Value Not a Deposit or Guaranteed by a Bank or any Bank Affiliate Gerstein Fisher is a division of People s Securities, Inc., a Broker/Dealer, member of FINRA and SIPC, and a registered investment advisor. People s Securities, Inc. is a subsidiary of People s United Bank, N.A. For Current and Prospective Client Use

Exhibit 1: A Hypothetical Efficient Frontier Risk vs. Return 10.5 10.0 9.5 Equity Commodities Bonds Exhibit 2: Risk and Return of the Four Indices Aug. 1, 1972 Jul. 31, 2012 Annualized Annualized Standard Deviation (%) S&P 500 Index [A] 9.94 18.26 MSCI EAFE Index (gross div.) [B] 9.10 21.95 9.0 8.5 Nareit (Equity REITs) [C] 12.07 18.46 S&P GSCI TR [D] 8.95 26.34 8.0 7.5 2.5 4.5 6.5 8.5 10.5 12.5 14.5 16.5 18.5 Risk (%) Source: Bloomberg; Ibbotson Sinquefield; Standard and Poor s Index Services Exhibit 3: Correlations of the Four Indices Aug. 1, 1972 Jul. 31, 2012 S&P 500 Index S&P 500 Index 1 MSCI EAFE Index NAREIT (Equity REITs) S&P GSCI TR in what is called the efficient frontier. The appropriate efficient portfolio for each investor depends on the individual s risk tolerance. An example of this trade-off between volatility and return is depicted in Exhibit 1. The Four-Asset Class Portfolio Now that we have described the benefits of diversification, let s look at how it works in real-world portfolio construction. We ll use four popular indices to represent the four asset classes in Gibson s original study and create portfolios using them. A. S&P 500: Proxy for the US equity market B. MSCI EAFE: Proxy for the equity market of developed countries outside the US and Canada (international stocks) C. NAREIT: Proxy for US equity real estate investment trusts (REITS) D. S&P GSCI: Goldman Sachs Commodity Index, a benchmark for commodities futures contracts The actual risk and return profiles and the correlation matrices of the four indices during the 40-year time period August 1, 1972 to July 31, 2012 are shown in Exhibits 2 and 3: MSCI EAFE Index 0.63 1 Nareit (Equity REITs) 0.58 0.44 1 S&P GSCI TR 0.077 0.18 0.03 1 Source: Gerstein Fisher Research, Standard and Poor s Index Services, www.reit.com and MSCI To test the benefits of diversification, we use the above four indices to construct various portfolios and examine their performance. Investing an equal amount in each index, the four indices can be used to construct a total of 15 different portfolios, including four single-asset portfolios. The possible combinations of portfolios are shown in Exhibit 4: Exhibit 4: The 15 Asset Class Portfolios Portfolio S&P 500 Index [A] MSCI EAFE Index (gross div.) [B] NAREIT (Equity REITs) [C] S&P GSCI TR [D] AB AC AD BC BD CD ABC ABD ACD BCD Remark 100% invested in each asset 50% invested in each asset 1/3 invested in each asset ABCD 1/4 invested in each asset Source: Gerstein Fisher Research, Standard and Poor s Index Services, www.reit. com and MSCI 2

So for example, a two-asset portfolio like AB represents 50% invested in US stocks [A] and 50% invested in international stocks [B]. A three-asset portfolio such as BCD represents one-third allocations in each of international stocks, real estate and commodities. Similarly, the ABCD portfolio is equally invested among the four asset classes. The Quest for Consistency To illustrate the importance of diversification in the real world, we ranked all the portfolios in terms of their annual returns for the past 12 years from January 1, 2000-December 31, 2011. Exhibit 5 shows each of the 15 portfolios ranked from best (top) to worst (bottom) in each year. Notice that nearly every one of the top-performing portfolios is a single-asset one, and that all of the worst performers are also single-asset portfolios. For example, in 2001 commodities (D) was the worst performer among the lot, but the next year it was the top performer. The wild swings in commodity returns are reflected in its high standard deviation, or risk, as seen in Exhibit 2. Now take a look at ABCD, the most diversified portfolio. This one is always ranked in the middle, irrespective of how other portfolios have behaved. In other words, this portfolio is built to provide stable returns with much less risk than single- or two-asset portfolios. Moving Out on the Efficient Frontier Note that Exhibit 5 is based only on returns. We also need to analyze the risk associated with these returns, since the major benefit of diversifying a portfolio is to reduce the amount of risk associated with individual asset classes. In Exhibit 6 on the next page we chart the risk (as measured by standard deviation) and returns of all 15 asset-class combinations from August 1, 1972-July 31, 2012. Exhibit 5: Year-by-Year Return Rankings of 15 Portfolios 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 D C D B C D C D AC B C C CD AC CD BC BC CD BC BD A BC AC AC C BC BD C CD BD B AD C ABC CD CD ACD ABC BCD ABC BCD BCD ABC ABD ACD AB BC ACD BCD ACD C AB AC AD AC B ABC AC ACD A AD CD ACD AC ABC ABD AB BCD ABCD C ABC AD BD A AD BCD ABCD ACD A AB BC ABCD ABCD ABCD ABCD ABCD ABCD ABCD ABCD ABCD ABCD ABCD AD A A ABC AC BCD ABD BD B B BCD CD AB BCD BCD D ABD AB BC ABD BD BC ACD ACD BCD ACD AD BCD BC B AC ACD ABD C CD A ABD ABD AB BC ABC ABD ABC CD D ABC ABD ABC CD BD ABD ABD A AD B A AB AB BD BC BD CD D AB AB BD AB AD AD AC AD AC B AD BD BD B D A D A A D C D D B B Source: Gerstein Fisher Research, NAREIT, Morningstar 3

Exhibit 6: Risk and Return of the 15 Asset-Class Combinations Aug. 1, 1972 Jul. 31, 2012 (With Quarterly Rebalancing) Multi-Asset-Class Investing Returns and Risk Standard Deviation (%) 27 25 23 21 19 17 15 13 11 9 S&P GSCI TR [D] MSCI EAFE Index (gross div.) [B] AB S&P 500 Index [A] BD ABD AD 7 8.5 9 9.5 10 10.5 11 11.5 12 12.5 Source: Gerstein Fisher Research, NAREIT, Morningstar As we can see in Exhibit 6, the benefits of creating diversified portfolios using multiple asset classes with dissimilar patterns of returns are powerful. When combining such assets, portfolios generally shift to the lower right quadrant: higher return and lower risk (as measured by standard deviation). In finance parlance and first described by Markowitz, this is the improved efficient frontier for portfolios: higher expected return for a given level of volatility, or lower volatility for a given level of expected return, as explained earlier. BC BCD ABC X ABCD AC NARIET (Equity REITs) [C] CD ACD More Asset Classes, Potentially Less Risk Note the consistent reduction in volatility as we move from single-asset to 3- and 4-asset class portfolios in the graph. Five of the six lowest-volatility portfolios were 3- or 4-asset class ones. Real estate had the second-lowest standard deviation after US stocks, but every multi-asset class portfolio had lower volatility than real estate. The 4-asset class portfolio reduced risk by one-third when compared to the average of the same four asset classes. Clearly, there will be periods during which domestic stocks will outperform foreign stocks (and vice versa), REITs will beat equities, and so on. But who among us has the clairvoyance to predict when these cycles will begin and end? This is why multi-asset diversification continues to make sense. Finally, we should note that our use of equally weighted multiple- asset- class portfolios is for the sake of demonstrating some important portfolio diversification principles and is by no means intended as a portfolio allocation recommendation. Conclusion In an industry prone to fads, thoughtful portfolio diversification is a long-term investment strategy that stands the test of time. By combining multiple-asset-classes with low or negative correlations, an investor may achieve a higher portfolio return and a significant reduction in risk. That almost sounds like a free lunch. It is also instructive to look at some specific examples in the graph. Commodities (represented by the S&P GSCI and letter D in Exhibit 6) had the lowest return and the highest risk during the 40-year period. But look what happens when this seemingly less attractive asset class is combined with others. For instance, when combined with US stocks, the two-asset portfolio (AD) has a higher return and lower volatility than US stocks alone, due to different return patterns and the quarterly rebalancing discipline. Overall, four of the five highest multi-asset-class returns had commodities in the portfolio since commodities had the strongest diversification potential when combined with other asset classes. Three of the four worst returns occurred in single-asset class portfolios. 4

This is a publication of People s Securities, Inc. doing business as Gerstein Fisher. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Past performance is not an assurance of future results. This presentation is for informational purposes only and should not be construed as an offer to buy or sell any financial instruments. Market indices referenced herein are unmanaged and representative of large and small domestic and international stocks and bonds, each with unique risks. Information about them is provided to illustrate market trends and does not represent the performance of any specific investment. International investments may be subject to currency fluctuations, potential political unrest, and other risks not associated with domestic investments. Remember, past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this document, will be profitable or equal any corresponding indicated historical performance level(s). Diversification cannot eliminate the risk of investment loss. Investments related to gold and other precious metals are considered speculative and are affected by a variety of world-wide economic, financial and political factors. Performance results have been compiled exclusively by Gerstein Fisher, and have not been independently verified. Gerstein Fisher maintains all information supporting the performance results in accordance with regulatory requirements. Due to various factors, including changing market conditions, the content of this presentation may no longer be reflective of current opinions, positions, or recommendations. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Gerstein Fisher. Please remember to contact Gerstein Fisher. if there are any changes in your financial situation or investment objectives or if you wish to impose, add or to modify any reasonable restrictions to our investment advisory services. Information pertaining to Gerstein Fisher s advisory operations, services, and fees is set forth in Gerstein Fisher s current disclosure statement, a copy of which is available from Gerstein Fisher upon request. 212-968-0707 info@gersteinfisher.com www.gersteinfisher.com FALL 2012/SPRING 2017