Diversifying Your Portfolio? What to Takeaway from 2018

Even though you are the expert of asset allocation, 2018 would prove to be a tough year for decent returns. Our research team at FinEX Asia has tracked the main asset performance until end of October, and we found that 85% of the asset classes reported negative returns YTD this year. According to a research published by Deutsche Bank, this ratio is the highest on record since 1901.

Source: FinEX Asia

The above chart details the performance of each asset class that we track and from which you could find out emerging market FX is not very impressive. Argentine peso came in as the worst performer, having lost half its value against the dollar, followed by the Turkish lira. Bad performance also plagued other traditional asset classes, ranging from Equity, Bonds to Commodities.

Source: FinEX Asia

The high percentage of assets coming in at negative returns meant that portfolio diversification aimed at reducing risk with traditional assets apparently is a money losing strategy. October 2018 alone has been disastrous for various asset classes due to several factors such as the rate hikes, political turbulence in EM countries as well as Brexit, escalating trade war between the United States and China, etc.

During the height of the 2008 financial tsunami, the Fed, together with other major Central Banks, imposed humongous stimuli that pumped billions into the market, swallowing up bonds and mortgage-backed securities, and in the process, pushed up all the risky assets. However, the Fed began normalizing policy in December 2015 demonstrating the Fed’s confidence in the strength of the economy. The Benchmark 10-year treasury yield ended at 3.16% in October 2018 and is expected to climb with a stronger than expected US economy, prompting the Fed to hike rates according to schedule. With the Fed continuing to roll back the Quantitative Easing (QE), the traditional risky assets are facing some selling pressure. Bonds have been falling for the past two years, and now with the 10-year treasury yield risen above 3.16%, the stock market has become more sensitive to yields. Normally a stock market sell-off results in a flight to safety into treasuries. However, for 2018, stocks, currency, commodity and bonds are showing a positive correlation, on the way down. This is reminiscent of the last rate hike cycle in the US lasted from 2004 to 2008, when bonds plummeted, and stocks were sold off, causing significant market volatility.

Which leads us to the million-dollar questions: what should investors do now? Is holding cash the only option left?

The main purpose of doing asset allocation is to take advantage of the correlation coefficient among different asset classes to diversify the risks among various market/ economic cycle. However, when it is not working, where do we find an asset class that is truly not correlated to any of current market volatility?

Studies showed that US consumer credit has low correlation with other asset classes and what is even more impressive is that there’s a positive correlation between consumer credit and the Fed rate. This is because consumer credit generally amortizes monthly and the principle paydown can be used to reinvest into new loans which is originated at the prevailing interest rate. Commercial loans and bonds, however, tend to be fixed-rate instruments, repaid in a single bullet payment at maturity. Further studies also showed that consumer credit tends to have a low correlation with traditional fixed income as a result of its credit exposure, which stems primarily from the consumer rather than from corporate or government credit exposure. The rate hikes elevate the net interest income of the banks in the US as well as the borrowing rate in consumer credit sector.The activities of consumer who borrows and repay money are not as sensitive as how fixed income instruments react to rate hike as the performance of consumer credit asset is heavily driven by demand and supply, as long as the consumer activity is booming, and credit quality which can be monitored by employment and household debt to income ratio (DTI) still demonstrate a strong growth, the asset classes will perform.

The consumer credit is in a unique position as it delivers a strong and remarkably stable return as long as the above-mentioned macroeconomic indicators continue to show strong data, and it does not respond to current turbulence of the market volatility brought by not only the rate hike but trade tension and other economic uncertainties. The fully-amortizing nature of the consumer credit, where lenders typically receive principal and interest monthly, if not more frequently, helps to lower duration. This is in contrast with traditional credit markets which are only repaid with the principals at maturity, or investors may trade them away at secondary market where their principals are at risk.

Source: RiverNorth white paper, 2017

The low correlation with traditional asset class facilitates the diversification of investor’s existing portfolio. As a result, the US$3.8 trillion consumer lending is a highly sought-after asset class, attracting big names such as Soros Fund Management, Blackrock and PIMCO to venture into it. 

Source: Bloomberg

Many fixed-income funds are buying assets from various platforms offering direct access into consumer credit loans, given their attractive and stable returns. Analysts project a $1 trillion addressable consumer credit market for marketplace lending platforms (excluding mortgages) and estimate loan origina­tion volumes could reach $90 billion by 2020.

To help investors reap the potential of prime US consumer credit, FinEX Asia Marketplace Credit Fund was launched in October 2017. Since its inception, the fund has achieved a yield of 7.39%, and it’s 2018 YTD performance is 5.55% with annualized yield of 7.42%. The performance is particularly standing out while 85% of the major asset classes are in red. Consumer credit has long- term being a major part of asset allocation of bank balance sheet and asset managers have started exploring adding this asset class into their portfolio. In the volatile world, investors should always review their current investment portfolios and adjust the asset allocation to the strategies with the risk profile that will reduce the correlation with the micro economy. It is the best way to defend against any potential black- swan worries and tail risk. In our view, investing US consumer credit is the investment you should have learnt from 2018.