As the Dow Jones Industrial Average (DJIA) and S&P 500 have fallen more than 5% from their recent highs, investors have rushed toward safety. Funds that aim to lower risk and limit stock market losses raised almost $10 billion in the first four months of 2019, The Wall Street Journal reported.
But there’s a much simpler, cheaper way to hedge your stock-market investments—bonds. And they’ve been the most effective way to do that for more than a decade. Recently, haven buyers have scooped up 10-year Treasury notes, driving yields down a full percentage point since last October, to as low as just above 2.20% at one point last week.
New research by Christine Benz, Morningstar’s director of personal finance, confirmed the superiority of bonds—especially Treasurys—as hedges over the long run.
Benz looked at asset classes traditionally considered stock-market hedges over different periods, from one year to 15 years. She used Morningstar Direct’s database and stuck mostly to funds and ETFs available to institutional and individual investors.
Benz looked at the correlation coefficient between different pairs of asset classes over time. That’s a number between -1 and 1 that measures how closely two variables move together. A correlation of 1 means the two are perfectly in sync, 0 means no correlation, and -1 means the two are going in the opposite direction. In short, it tells us how much other assets have zagged when stocks zigged, and vice versa. Ideally, to hedge your equity risk, you’d want something that has as negative a correlation with the S&P 500 as possible.
“The goal is when stocks tumble, that you have something in your portfolio with the ability to at least hold its ground, or maybe even earn a little bit,” said Benz. That’s important for maximizing your holdings’ long-term growth.
This table tells the story.
Bonds: The Best Hedge
|Five-year correlation||Ten-year correlation||Fifteen-year correlation|
|Asset class||with S&P 500||with S&P 500||with S&P 500|
|Bloomberg Barclays U.S. Aggregate Bond||-0.05||-0.13||0|
|Bloomberg Barclays U.S. Treasury 20+ Year||-0.18||-0.46||-0.3|
|Bloomberg Barclays U.S. Treasury 5-10 Year||-0.28||-0.37||-0.28|
|SPDR Gold Shares (GLD)||-0.18||0.06||NA|
Real estate, often recommended as a portfolio diversifier, actually is highly correlated with stocks — 0.74 over 15 years. Managed futures, which have been touted by some investment advisers, are mediocre hedges at best, showing positive correlations with stock prices. Developed and emerging markets international stocks had similarly high correlations with U.S. equities over the past 10 to 15 years, as did high-yield bonds. Long-only commodities also were highly correlated with stocks — 0.4 to 0.5.
Gold was an excellent hedge over the past five years and cash did its job over the last 15; both were solidly in negative territory over those periods.
Then there were two categories—long-short equity and market-neutral—that supposedly mimic the strategies of hedge funds. Their high correlation with stocks (up to 0.97 for long-short and 0.47 for market-neutral) point to why the only thing hedge funds have successfully hedged against over the past decade has been good returns.
But the big winner across the board was bonds. The Bloomberg Barclays U.S. Aggregate Bond index (AGG)—which covers a broad swath of Treasury, agency, and investment-grade corporate bonds—had zero correlation with stocks for 15 years, but negative correlations over five and 10 years.
Treasurys did even better protecting against equity risk, and here’s the big surprise: Treasurys with maturities longer than 20 years weren’t much better at protecting your portfolio than intermediate-term Treasurys; over the past five years, they did worse.
That’s great news for investors, because intermediate-term Treasurys—those with maturities of five to 10 years—are less interest-rate-sensitive and less volatile than long bonds.
In that category, I like the Vanguard Intermediate-Term Treasury ETF (VGIT) the SPDR Bloomberg Barclays Intermediate Term Treasury ETF (ITE) or the Schwab Intermediate-Term U.S. Treasury ETF (SCHR). All have full exposure to intermediate Treasurys and rock-bottom expense ratios.
Bonds haven’t always been good hedges; in the four decades before the 1990s, stocks and bonds had positive correlations, a study by Graham Capital Management found. But I doubt the complex alternative investing products the ETF industry has concocted over the past few years would have done better—if anybody can figure out how they actually work.
“So, the takeaway is that for most investors, at least based on…history, simpler and cheaper has been better than investing in alternatives,” said Benz.
Nobel Prize-winning economist Harry Markowitz reportedly called diversification “the only free lunch in finance.” If that’s true, then bonds, especially Treasurys, are the only free dinner.