Section 01 A Banner Year for the S&P 500
Despite significant uncertainty, markets posted a banner year in 2021, with the S&P 500 total return rising over 28 percent. By historic measure, that’s outstanding — but it wasn’t the best-performing asset class. Every year (as we say every year), there’s bound to be an asset class that surprises the investing world, and 2021 was no different. After finishing 2020 as the worst-performing asset class (declining 11.2 percent), REITs significantly outperformed in 2021, returning 45.91 percent for investors.
What was last shall be first, as it was once said.
“Buoyed by attractive valuations, a healthy dividend yield and optimism the economy will continue to inch toward normalcy, REITs came roaring back to the top of the table after being the worst performer in 2020,” says Steve Bruce, senior investment consultant at Northwestern Mutual.
And bolstered by inflationary conditions, Commodities jumped to the third-best performing asset class, returning 27.1 percent for investors following a decline of 3.1 percent in 2020. It was a year that crystallized something we say often: Asset classes may fall asleep from time to time, but they never die. It’s why we have viewed and continue to view broad diversification as a critical strategy for long-term investors.
Section 02 Why Diversification Works in 1 Chart
Following the close of every calendar year, we pen an article that promotes what we call “the quilt.” It’s simply a color-coded chart that ranks, from highest to lowest, the returns of various asset classes each year. When you map it out across 15 years, you get something that looks like a quilt that’s been stitched with no rhyme or reason. It’s a mess, and that’s precisely the point. It poignantly illustrates the unpredictable nature of markets and why it’s so important to remain diversified for the long term.
Asset Classes Go In and Out of Favor
As often happens, there’s a tendency for investors to follow the trend and pile into the winning class at the expense of diversification. Why hold, say, Bonds or Emerging Market stocks when they were clear laggards in 2021? Well, just look to the turnaround in Commodities and REITs from 2020 to 2021. Now, this isn’t a call to chase these leaders; rather, a well-constructed portfolio should have already reaped the benefits of these turnaround stories.
“Since 1999, there have been only three instances of an asset class being the top performer in consecutive years. The short-term unpredictability we see in asset class returns is precisely why diversification is important for investors,” says Bruce.
We always urge investors to avoid a “what-have-you-done-for-me-lately” type of analysis when it comes to portfolio building. Successful investors focus on winning the intermediate- to long-term game, not the short game, which is impossible to consistently win (as “the quilt” shows). Indeed, investors who avoid following trends participate in returns over time generated by various assets as they move in and out of favor.
Few could have anticipated the sharp — and rather persistent — uptick in inflation in the second half of 2021 that benefited REITs and Commodities. However, long before rising prices stole headlines, we were highlighting the important role these asset classes play hedging inflationary uncertainty. At the time, REITs and Commodities were hardly in favor. Again, every asset in a portfolio serves a purpose.
“Long-term investors are building portfolios, not just collecting asset classes. Each asset class serves a purpose in a portfolio and often acts as a hedge against the unexpected,” says Northwestern Mutual Chief Investment Strategist Brent Schutte. “This is a critical concept. Even though one asset class may finish on the bottom in terms of returns over a year, it still serves a purpose.”
That rings true for Fixed Income, which trailed in performance. It was just the fourth time since 1976 that the broad bond index (AGG) was negative for the year. (The other three were 2013,1999 and 1994.) But Fixed Income remains an important ballast in portfolios, as investors still turn to it as a haven in volatility, and remains a vital option for liquidity and safety. Keep in mind, over the past 46 years on a total return basis, there has not been a single instance when both the S&P 500 and the AGG were negative in the same year.
Section 03 Looking Ahead Into 2022
As we look ahead to 2022, keep this asset class performance chart front of mind. Inflation will remain a focus; the Fed is embarking on tapering and may raise rates two or three times. Pockets of U.S. markets certainly look relatively expensive. Though its deepest economic repercussions are likely in the past, the pandemic remains a wild card. And these are simply the “known unknowns.” Every year presents investors with a curveball. How is an investor to prepare? Simply admit you can’t perfectly predict the future in the near term. Long term, of course, it’s possible to build reasonable forecasts based on historical trends and the trajectory of the broader economy.
Take a little closer look at the quilt. You’ll notice there’s one square offering some semblance of consistency – it’s the white “diversified portfolio” patch. Rather than a single asset class, the diversified portfolio is a melting pot containing every asset class on the quilt. It represents a portfolio with the following weightings: 23 percent U.S. Large-Cap; 6 percent U.S. Mid-Cap; 3 percent U.S. Small-Cap; 13 percent International Developed; 6 percent International Emerging; 4 percent Real Estate; 5 percent Commodities; 38 percent Fixed Income (bonds); and 2 percent Cash Alternatives.
It’s got a little bit of everything, which means it’ll hold the top-performing asset class and the worst-performing asset class at the same time. By design, a diversified portfolio will never take that top spot in returns, but it also won’t finish at the bottom. Rather, it has reliably produced middle-of-the-road returns relative to any single asset class. Over the course of decades, this may help mitigate your exposure to the ups and downs of any single investment in your portfolio.
“In the years between 1999 and 2010, U.S. Large-Cap stocks never finished in the top third of asset class performance,” says Bruce. “Since 2011, they’ve been a top-third performer nine times. In just a little over a decade, investors went from eschewing large-cap stocks to overweighting them in their portfolios. Diversification helps solve this all-or-nothing mindset and can help steer investors away from chasing performance.”
Of course, more aggressive investors may be willing to accept more risk in search of more return. They may not allocate as much of their portfolio to Fixed Income, for example. Still, even an aggressive investor is well served by having some exposure across the spectrum of asset classes.
That’s the beauty of diversification, and those who stick with it may be in a stronger position — especially if markets look much different in 2022 and beyond.
The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and non-proprietary sources. Indexes are unmanaged and cannot be invested in directly. No investment strategy can guarantee a profit or protect against a loss.
Sources for asset class chart:
U.S. Large Cap: The S&P 500 Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
U.S. Mid Cap: The S&P MidCap 400 measures the performance of 400 mid-sized companies in the U.S., reflecting this market segment’s distinctive risk and return characteristics.
U.S. Small Cap: The S&P Small Cap 600 Index is a market-value weighted index that consists of 600 small-cap U.S. stocks chosen for market size, liquidity and industry group representation.
Int’l Developed: The MSCI EAFE Index (Europe, Australasia and Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom.
Int’l Emerging: The MSCI Emerging Markets (EM) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of the emerging-market countries of Europe, the Middle East and Africa. The Index consists of the following emerging-market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Russia, Qatar, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.
Real Estate: The Dow Jones U.S. Select REIT Index intends to measure the performance of publicly traded REITs and REIT-like securities. The index is a subset of the Dow Jones U.S. Select Real Estate Securities Index (RESI), which represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the U.S. The indices are designed to serve as proxies for direct real estate investment, in part by excluding companies whose performance may be driven by factors other than the value of real estate.
Commodities: The Bloomberg Commodity Index (BCOM), formerly the Dow Jones-UBS Commodity Index, is a highly liquid, diversified and transparent benchmark for the global commodities market. It is calculated on an excess return basis and reflects commodity futures price movements.
Fixed Income: The Barclays Capital U.S. Aggregate Bond Index (formerly the Lehman Brothers U.S. Aggregate Index) is an index of the U.S. investment-grade fixed-rate bond market, including both government and corporate bonds.
Cash Alternatives: Cash alternatives are represented by the Citigroup 3-month Treasury Bill Index, an unmanaged index representative of three-month Treasury bills.
Diversified Portfolio: A portfolio of all segments disclosed above, with the following weightings: 23% U.S. Large Cap; 6% U.S. Mid Cap; 3% U.S. Small Cap; 13% Int’l Developed; 6% Int’l Emerging; 4% Real Estate; 5% Commodities; 38% Fixed Income; 2% Cash Alternatives.