Diversification is key when markets go into a tailspin

Author: Matthew Pierce

Covestor models: Income Portfolio, Growth Portfolio, Balanced Portfolio

Disclosure: None

May is very rarely a great month for US equity investors. This May was, unfortunately, not an exception to the old rule to “sell in May, buy in October.” Don’t get us wrong: we are not advocating a tactical strategy that moves portfolios to cash for 6 months out of the year.  We are just saying that all of us would have been well served to reduce equity exposure at the end of April.

While US equities dropped 6.2% in May, European and emerging market equities declined even more (11.4%). Factors affecting international equities included a strengthening US dollar, the increasingly likelihood of a European recession and declining growth prospects in China and other export economies.

Fixed income investments were a stabilizing force in May (up 1.2%) and US Treasuries were particularly buoyed by a flight to quality.  Investors fears of stagnant economic growth, combined with uncertainty about the Euro and worries about credit quality and government support of European bonds offset continued expansive monetary policies in the US and abroad.

One of the benefits of investing in a diversified portfolio of equities, bonds and alternatives is that when months like May come around, the less volatile securities, like short-term corporate bonds, typically protect from losses due to equity exposure.  We build our more conservative portfolios to be less volatile and to lose less in down months.  The more conservative portfolios have performed as we expected in this regard.

Some of our explicit exposures in the current portfolios are a relative underweight in Europe and international markets overall, a relative overweight in riskier assets, including emerging market and smaller capitalization equities.  We retain a large exposure to gold and treasury inflation protected bonds which we consider good diversifying assets.

The table below reflects our composite portfolio performance for the month of May and since 12/31/2011.  Returns are net of fees and transaction costs.

We measure our portfolios against an index of US fixed income investments (the BarCap Govt/Credit Index) and an equal-weighted index of Large US Stocks (Russell 1000 value) and non-US stocks (MSCI ACWI ex US).

Island Light’s investment process is designed on a process that we call Enlightened Investing.  Enlightened Investing is a stable approach to portfolio management, emphasizing quantitative principles and proven investment practices, while accentuating asset allocation as the most important determinant of long term success in investment planning.  This approach is designed for the long term investor.

While disappointed with our returns in May, we remain optimistic for long term global equity returns which reflect global economic growth prospects and have no plans to change our approach or our positions in the short term as a response to short term setbacks.