Just What Should You Expect From Diversity? You May Be Surprised
You can run from a stock market crash or correction, but there aren’t a lot of places to hide: Among mutual funds, only money market portfolios provide reliable short-term protection.
So says researcher Morningstar Inc. of Chicago in a recent study that offers some lessons that are becoming increasingly relevant in light of Wall Street’s summer swoon.
Morningstar examined how much diversification bang you can expect from owning various types of funds. The conclusion: not much.
“International funds don’t protect you against short-term dips, but neither do such traditional diversifiers as bond, real estate or gold funds,” wrote associate editor Olivia Barbee in the July issue of the Morningstar Fund Investor newsletter. “If you’re trying to guard against sudden losses, buy a low-cost money market fund.”
It’s no surprise that money market funds hold their ground when stocks are headed south. These investments feature stable prices at all times, reflecting their holdings in Treasury bills, certificates of deposit, short-term corporate IOUs and other safe instruments.
But the performance of foreign, real estate and gold funds is a bit of an eye-opener. Plenty of people have bought into these categories in recent years in the hopes of smoothing out their overall performance. Morningstar’s study suggests that they won’t get much protection, at least over the short haul.
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Morningstar examined results for the 12 worst calendar months of the last decade, when the Standard & Poor’s 500 index lost at least 3% each time. Diversified U.S. stock funds tumbled on every occasion, as you would expect. But bond funds also fell in seven of those 12 months, as did gold funds. Broad-based foreign stock portfolios fell on 11 occasions. Funds that invest in emerging foreign markets dropped all 12 months, as did portfolios of real estate stocks.
The lack of protection provided by foreign funds was particularly frustrating in Barbee’s view.
“Like many investors, I bought these funds to lower my risk and improve my returns, but they’ve done just the opposite,” she complained.
Real estate funds are another key category that hasn’t delivered much downside protection lately. The funds invest mainly in specialized companies known as real estate investment trusts.
“REITs are stocks, and they react to some of the same pressures that the stock market feels,” said Karen Knudson, a Chicago-based co-manager of the American Century Real Estate Fund. “However, if you go out a year or more, REITs tend to track real estate fundamentals rather than whip around with the stock market.”
In fairness, Morningstar’s study offers only a partial answer to the diversification question. Ibbotson Associates of Chicago earlier this year examined how well various asset classes held up during the six occasions since 1973 when the U.S. stock market tumbled at least 10%. The study included the bear market of 1973-74, the crash of October 1987 and corrections that began in 1975, 1976, 1980 and 1990.
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Ibbotson’s conclusion was that cash, gold, REITs, bonds and foreign shares all held up better than large U.S. stocks during these traumas--and thus provided diversification protection. In fact, cash, gold and bonds each generated positive returns, while foreign stocks and REITs fell roughly half as much as domestic blue-chip stocks.
“Long term, these assets still provide significant diversification, even during crash periods,” Matt Kammerzell, an Ibbotson consultant, said. Although the firm’s study focused on asset categories rather than the mutual funds holding those investments, the results are still relevant.
Even Morningstar’s study of one-month returns pointed up some diversification benefits of owning investments other than just U.S. stocks or stock mutual funds.
For example, although real estate funds slipped in all 12 down months, they dropped less sharply than broad stock funds on all but two occasions. Bond funds did even better, falling less dramatically during each of the seven months that they, along with stock funds, lost ground.
Two key lessons emerge from these studies. First, you can reap diversification benefits from investments such as foreign stock funds even if they fall in price--provided they drop less sharply than your U.S. stock market holdings.
Second, the benefits become more apparent if you give your investments more time to work.
“Diversification doesn’t necessarily mean you’ll get the best performance over any particular time frame,” said Mark Riepe, who heads Charles Schwab’s Center for Investment Research in San Francisco. “The goal is to get a smoother ride over the long haul.”
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Russ Wiles is a mutual fund columnist for The Times and co-author of “How Mutual Funds Work,” published by Simon & Schuster. He can be reached by e-mail at russ.wiles@pni.com.
