Brent Sheather: Beware the third quarter

Useful insight can be gained by looking at what asset classes have historically coped best at a time that shares have fallen. Photo / iStock

Brent Sheather is an Authorised Financial Adviser and a personal finance and investments writer.

Stock markets have hit a bumpy patch with the global equity benchmark now down by around 11% in US$ terms since its 2015 high point.

Many local share investors will be wondering what happens next and what strategies are appropriate.

Some useful insight can be gained by looking at what asset classes have historically coped best at a time that shares have fallen. This is just what Cliff Asness and his team at AQR have done recently and the findings make interesting reading.

Mr Asness is the Principal of hedge fund AQR Capital. He has a PhD in finance from Chicago and has previously lectured at Yale and MIT. He looked at the ten worst quarters for global equities since 1972 and the performance of various asset classes and strategies in these quarters.

Inexplicably positive thinking and power dressing strategies weren't considered by the AQR team as a hedge against a generalised equity shake out.

Anyway what conclusions did the AQR team reach?

First off the average of the ten worst quarters for global shares in US$ terms was a loss of 19.1% with the worst quarter being fourth quarter 1987 with a fall of around 27%, according to AQR data.

Interestingly six of the ten worst quarters were September quarters and coincidentally the September quarter thus far has been a big down quarter too with global equities falling by about 7.0% in US$ terms.

So what worked? No surprises that one of the best performers at a time when shares lose favour was high quality bonds. The average return from a bond portfolio over those ten quarters was 3.9% so the traditional 40% bonds, 60% shares balanced portfolio reduced the 19% loss on an all equity portfolio to a less scary -10%. It is worth thinking for a minute why bonds often do well when shares do badly.

If you have a share portfolio and you want to limit the impact of disasters it is sensible to own a few high quality long dated bonds.

The reason is that companies are valued because of their profits and profits are a function of sales and sales are a function of many things including the health of the economy. Recessions and depressions are bad news for shares because they are associated with depressed levels of economic activity and thus profits.

Furthermore in this sort of scenario inflation levels normally fall and on really bad occasions can go negative. This environment raises the after-inflation value of bond coupons. In addition when "animal spirits" take a turn for the worst people frequently flock to low risk asset classes, along with putting in vegetable gardens and buying firearms.

The other big winner in a negative equity environment was, surprisingly, gold which averaged a 4.2% return. That doesn't look likely this quarter however.

The other interesting result from the AQR analysis was that, despite their name, hedge funds didn't totally protect investors from a downturn. Although the hedge funds data only goes back to 1990 the AQR analysis suggests that when stockmarkets decline hedge funds do too although not to the same extent.

The reason being that hedge funds are either long equities or long other assets which go down with shares. In the hedge funds subsectors only two had positive average returns when stock markets fell - dedicated short bias and trend following.

The conclusion that hedge funds aren't a great hedge is further strengthened, for retail investors anyway, firstly by the fact that the analysis is before fees and secondly by the fact that unless you are well connected you only get access to the worst hedge funds. Recall that infamous comment in the Financial Times a few years back where a cynical investor commented he would never buy units in a hedge fund that he was able to get access to.

Any useful takeaways for today's environment from the AQR analysis?

The main one is that if you have a share portfolio and you want to limit the impact of disasters it is sensible to own a few high quality long dated bonds. The experience this quarter confirms that wisdom as bond yields appear to be falling with the stockmarkets despite the Federal Reserve intimations that interest rates will rise. It seems that no one believes that story.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent may have an interest in the companies discussed.