The ‘investor revolt’ continues. According to Investment Company Institute, U.S. equity funds had outflows of $17.5 billion in August on top of the $28.58 billion in July. These are very serious numbers. Overall, investors have pulled $50.3 billion out of U.S. equity mutual funds in the past quarter. What is also staggering is that they also withdrew $46.18 billion from bond funds during the same period. Seems like Main Street is fed up with risk and wants to be rid of it. At RiXtrema, my colleagues and I have warned our clients about increasing risk levels since at least June of 2015, as have many other risk managers. So, at first look it seems like a sensible step for investors to take some risk off the table.
But what did investors do with that money? It appears that they shifted a significant amount to international stocks and money market funds! Investors put $30.7 billion into international stock funds and $56.6 billion into money market funds during the past quarter.
Diversify Internationally? Only If You Want To Suffer Twice
The move to international stocks was likely prompted by the concept of diversification. However, there is a significant problem of diversifying U.S. equity exposure with international or emerging market equity. I know many textbooks and websites will suggest this approach, but there is no evidence that such diversification works. The correlations rise significantly in the tail and any diversification benefit from international or emerging markets equity simply vanishes. It is extremely unlikely for U.S. stocks to have significant losses and, at the same time, to have international equity act as a diversifier of risk. The investors in both equity markets are very much intertwined and losses in one will quickly lead to losses in the other. The past two months certainly provided another bit of evidence in that regard. Contrary to what Modern Portfolio Theory suggests, diversification benefits of spreading your equity exposure are very limited, because equity markets have become more and more correlated over the past two decades. This is what Rick Bookstaber called “tightly coupled markets.” Tight coupling is an engineering term that describes an interconnected system where failure in one part is likely to cause failure in other parts. Sound familiar? Yes, these are today’s financial markets (e.g., subprime debt, Greece, China).
Argument #1 For Treasuries: They Are Great Risk Diversifiers.
Why did investors not put their money into Treasuries? Clearly, they went with money market funds because those are basically riskless cash equivalents. Treasuries do carry interest rate risk of course and investors need to keep that in mind. However, what many investors and advisors miss is that a Treasury bond is one of the very few truly diversifying investments that we have available— perhaps even the only one outside of cash. International equities cannot diversify because, under stress, they are highly correlated with equities in the U.S. Most corporate debt funds are not great diversifiers in tail events. For example, corporate spreads have shot up significantly in 2008, inflicting heavy losses on corporate debt, even investment grade. But Treasuries have a very stable negative correlation with equity markets of about -.35. That diversification does not disappear during stress.
Argument #2 For Treasuries: Supply And Demand.
There is always demand for Treasuries because many institutions, such as banks, pension plans and others, are legally required to hold them. They are widely used as collateral for financial operations. When some bonds mature, the institutions have to acquire new ones. Additionally, much of the Fed stimulus has taken place through the Treasury markets. The Fed was buying so many Treasuries that it actually caused shortages. How is it possible you ask, for a virtual piece of paper to be in short supply? Alas, it is possible when many investors are required to own them (and so have to buy or can’t sell them) and the Fed decides to buy some as well. In fact, here is a Bloomberg story from a few months ago with some details on how it’s possible to issue lots of new debt and still be short of the underlying instruments.