Back to Frontier Insights

Nothing’s Perfect

09 March 2018

By Gary A. Miller, CFA®
Founding Principal

From January 29th through February 8th, the S&P 500® Index of large cap US stocks lost investors 10.1%. That in itself is not unusual; the Index has now lost more than 10% three times in the last three years, and nine times in the last ten years. What is unusual is that long-term US Treasury returns were also negative, down 3.6%, and that was a disappointment to all of us at Frontier Asset Management, since most of the time we can rely on Treasuries to rally when stocks are falling. Only once of the previous ten times that stocks were down over 10% did long-term Treasuries decline, too. After the recent occurrence, that statistic is now two out of ten.

Correlation between asset classes is a key factor when we design our strategies’ asset allocation mixes within our Downside First Focus methodology.  Correlation is a statistical measure of the degree to which two asset classes move together. For risk management purposes, the lower the correlation between two asset classes, the better. Therefore, a good risk management pairing is often stocks and long-term Treasuries, which actually have had a negative correlation to each other for more than twenty years. The table below, which many of you have seen before, is updated through the recent stock decline.

The correlation between the 2 asset classes is distinctly negative, particularly when stocks are getting hammered. In the book, “Expected Returns”, author Antti Ilmanen says it better than I ever could. He says, “some safe haven assets like government bonds are not only “good diversifiers,” they diversify best just when diversification is most needed.” But nothing is perfect. In fact, we know the correlation between stocks and long-term Treasuries is not -100%. That’s what it would be if every time stocks went down, long-term Treasuries went up a commensurate amount, considering the volatility difference between the two asset classes.

When I was a young engineer, my first boss taught me how to do rough mathematical calculations “on the back of a brown paper bag.” When we do that using the table on page 1, and I invite you to do this along with me, it looks like there are three times when the correlation is very negative, or somewhat close to -100%. There are another three times, when it looks like the correlation is pretty negative, but maybe more like -50%. There are another 2 times when the correlation is close to 0%, and then those pesky two times when the correlation is positive, but not too positive, so maybe around +50%. We can now estimate the correlation between the S&P 500® and the Bloomberg Barclays long-term Treasury Index as:

  • 30% of the time at -100% equals -30%
  • 30% of the time at -50% equals -15%
  • 20% of the time at 0% equals 0%
  • 20% of the time at +50% equals +10%

Adding those all up gives us the correlation estimate for all ten occurrences when stocks were down more than 10%, which is therefore -35%.

One of the interesting (and somewhat unique) statistical techniques that Frontier employs is that when it calculates the correlations between asset classes, it only counts periods when an asset class has a somewhat dramatic move up or down (of course, in true Frontier fashion, we weight the down periods more than the up periods). We do this because if we are really worried about managing for downside risk (and we are!), we don’t want the correlation between asset classes to be impacted by what are only minor market movements that have no bearing on downside risk. You may be thinking (hoping!) that Frontier actually doesn’t calculate correlations on the back of a brown paper bag. You are right; the actual correlation Frontier currently uses between large cap US stocks and long-term Treasuries when stocks are making big market moves is -34%. Quite different from than -35% calculated above?! Don’t you just love math!

Long-term Treasuries can be scary when interest rates are rising; there are very few times when you would own long-term Treasuries without stocks in a portfolio to hedge against Treasury declines, and the return for risk characteristics over long periods of time are not very good. That is why most investors use shorter-term bonds and cash equivalents to hedge against stock market declines – they focus too much on the individual pieces of a portfolio and not the whole portfolio. The table below adds the Bloomberg Barclays Aggregate Bond Index (a standard benchmark for high quality intermediate bonds even though it includes both short-term and long-term bonds), and 3-month T-bills (a good proxy for money market funds) to the table above.

It is easy to see that long-term Treasuries are a much better complement in a portfolio that includes a lot of equities. Not only do they generally have higher expected returns than intermediate bonds and cash equivalents, they perform better when stocks are falling.

But there’s more to the story. A big fear in the market-place is what happens to long-term Treasuries if interest rates on long-term bonds rise – and we all know they will someday. The table below shows how stocks do when Treasuries are in the tank. They generally do extremely well!

During each of the last ten times when the Bloomberg Barclays long-term US Treasury Index lost more than 7%, the S&P 500® had a positive total return. During seven of those periods, the S&P 500® returned more or almost as much as long-term Treasuries lost and the average gain of the S&P 500® Index exceeded the average loss from the long-term Treasury index (Unfortunately, during the most recent Treasury decline, stocks did not help much). Diversification cuts both ways. When Treasuries are performing poorly, stocks are the diversifying asset class that keeps the portfolio losses in check. In line with the results from the tables above, our correlation model actually shows a more negative correlation between stocks and Treasuries when Treasuries are falling than when stocks are falling.

A few closing comments. This was just a discussion about correlation and how used wisely it can reduce downside risk. However, the reason that long-term Treasuries are important in many of the Frontier strategies today is that the long-term return expectations for equity asset classes across the board are relatively low. When return expectations are low, the chance for a strategy to lose more than its downside risk target increases. We find that our strategies have higher future expected returns using Treasuries to help keep risk aligned with our targets than if our strategies simply held less equity and more cash equivalents.

If return expectations for stocks were higher, our strategies could hold more equities and still maintain the same downside risk targets. The higher the return expectations for equities, the lower is the need for long-term Treasuries. Furthermore, low yielding Treasuries are less likely to find homes in our strategies than if they are higher yielding. Downside First Focus is about return, too.

One last note. After all of this discussion, you may be wondering why did stocks and Treasuries fall in sync last month? As with most short-term market movement, no one knows for sure. As good a reason as any might be investors are worried the Federal Reserve Board has not been raising short-term interest rates quickly enough. That might imply that rates will go up more than previously expected – which could hurt equities, and it might mean that inflation is worse than previously expected – which would hurt Treasuries. During the more recent decline of March 12th through March 23rd, though, the S&P 500® lost 7.1%, while the Bloomberg Barclays long-term US Treasury Index returned 1.6%. That is just about as expected for a correlation of -34% between the two indices. Maybe the correlation between stocks and Treasuries is now back to normal. No one knows for sure.

Past performance is no guarantee of future returns. Nothing presented herein is or is intended to constitute investment advice or recommendations to buy or sell any types of securities and no investment decision should be made based solely on information provided herein. There is a risk of loss from an investment in securities, including the risk of loss of principal. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable or suitable for a particular investor’s financial situation or risk tolerance. Diversification and asset allocation do not ensure a profit or guarantee against a loss. All performance results should be considered in light of the market and economic conditions that prevailed at the time those results were generated. Before in vesting consider objectives, fees and expenses.

Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Exclusive reliance on the above is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. Information provided herein reflects Frontier’s views as of the date of this newsletter and can change at any time without notice. Frontier obtained some of the information provided herein from third party sources believed to be reliable but it is not guaranteed and Frontier does not warrant or guarantee the accuracy or completeness of such information. The use of such sources does not constitute an endorsement. All calculations by Frontier Asset Management, LLC.
Any forward looking statements or forecasts are based on assumptions and actual results are expected to vary from any such statements or forecasts. No reliance should be placed on any such statements or forecasts when making any investment decision.
In reviewing any performance information presented here, we recommend that you consider both the returns generated and the level of risk that was assumed in generating those results. We believe that performance information cannot be properly assessed without understanding the amount of risk that was taken in delivering that performance. The performance information presented here covers different time periods. We present performance information for short time periods because we understand that clients and potential Investors are interested in this information, however, we recommend against making any investment decisions based on short-term performance information.
Frontier’s ADV Brochure is available by request at no charge at or 307.673.5675.
Frontier’s performance is available on our website –
It is generally not possible to invest directly in an index. Exposure to an asset class or trading strategy or other category represented by an index is only available through third party investable instruments (if any) based on that index.
Index Index Description
S&P 500®
Represents US large company stocks. It is a market-value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ
Barclays US
Aggregate Bond
Measures the performance of the U.S. investment grade bonds market. The securities must have at least one year remaining to maturity, must be denominated in U.S. dollars and must be fixed rate, nonconvertible and taxable.
Barclays Capital
Long U.S. Treasury
Includes all publicly issued, U.S. Treasury securities that have a remaining maturity of 10 or more years, are rated investment grade, and have $250 million or more of outstanding face value

Frontier Insights

Gary’s Thoughts