Can cash be used as a diversifier?

A recent study by Ben Carlson showed “the only one of the [US-based] three major asset classes that’s up this year is actually cash”. Carlson has found out that “it’s only happened 10 times in 92 years”. I decided to apply the same analysis to UK-based investors, who have not benefited from several interest rates hikes in 2018.

Given the noise created by the Brexit negotiations, I decided to study six asset classes instead of three; I split fixed income between Gilts and non-Gilts, UK equities, international equities, emerging markets equities and cash. I used the IA Money market sector as a cash equivalent, to take into consideration the cost to access money market funds. The table below shows the returns from those six asset classes since 1997.

Return comparison across asset classes

Source: FE

2016 and 2017 were two exceptional years when all asset classes returned positive performances, but things reversed strongly in 2018. Only UK Gilts and cash managed to return positive returns to investors in the UK.

Since 2011, equity markets have barely experienced any sell-offs. But in 2018, we had two sell-offs - in February and in the third quarter, with strong market rotations away from technology stocks and the so-called FAANG (Facebook, Apple, Amazon, Netflix and Google). The US Federal Reserve’s (Fed) tightening cycle further led to the underperformance of fixed income markets. Although the UK Gilts markets managed to limit its losses and acted as safe-haven for Sterling investors, it wasn’t fully immune to the Fed’s hikes and returned -70bps this year so far.

Since 1997, cash has never outperformed other asset classes. In 2008, however, cash outperformed all asset classes barring UK Gilts, which returned 12.81% after the Bank of England cut interest rates. While it did well relative to risky assets in 2001 and 2002, it failed to outperform bond markets. 2018 therefore appears to have been an exceptional year for financial markets.

It is also interesting to look at the performance of multi-asset sectors as represented by the IA Flexible or IA Mixed sectors. These sectors have on average returned negative performance throughout 2018. Contrary to multi-asset fund managers, absolute return managers don’t rely (or should not) on positive directionality of financial markets to generate positive returns. They also failed to do so in 2018, as they failed to benefit from rising levels of volatility.

It seems to me that ‘diversification’ went missing last year. Most asset allocators talk about the diversification benefits achieved from mixing bonds with equities in a single portfolio. This statement is based on a return analysis made from 2000 – a period characterised with low (or lower) interest rate levels and almost no inflation. 2018 differs as inflation expectations and interest rate levels increased through the year.

Looking at the performance of traditional asset classes in the 70s, it may appear that inflation reduces the traditional diversification benefits of mixing equities and bonds as bonds tend to underperform in periods of high inflation. So, if your expectations for higher inflation persist in 2019, you should have another look at cash as a suitable diversifier.

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