The Sleep Easy Portfolio: Did Asset Allocation Work During the Coronavirus Market Crash?

In February we introduced a concept called The Sleep Easy Portfolio: How to Sleep Easy in Any Market Environment With Just Four ETFs.

We had no idea that a historic market crash and ensuing bear market was right around the corner as a result of a global pandemic. While the news has been pretty terrible for most investors, it does provide us with a great mini-case study to test how the concept of asset allocation, which The Sleep Easy Portfolio was based on, performed against a more aggressive 100% stock portfolio, as well as the classic 60/40 portfolio favored by more conservative investors.

Below we provide an update on the performance of The Sleep Easy Portfolio through the turbulence of the first quarter of 2020.

What is The Sleep Easy Portfolio, again?

The Sleep Easy Portfolio is constructed with four ETFs to maximize asset allocation and diversification benefits with as few funds as possible.

The idea came to us after reviewing the performance of a simple 50/50 split between US stocks and long-term treasury bonds, which at the time of writing had produced healthy high single digit returns annually while never losing more than 8% going all the way back to the lates 1970s. We use the popular ETF SPY to capture the US stock market exposure, and TLT stands in as the most liquid long-term treasury bond ETF. We then added two additional ETFs, the emerging markets small-cap ETF DGS, and the popular gold ETF GLD to enhance diversification and potential sources of return.

You can read all about the theory and construction decisions behind The Sleep Easy Portfolio in our original post on the topic here.

How did The Sleep Easy Portfolio perform compared to an all-stock portfolio and the classic 60/40 portfolio during Q1 2020?

If there was ever a stress test to see if an asset allocation would hold up, then the first quarter of 2020 provided it. On the whole, we were pretty pleased with the results:

Q1 2020 Overall Return and (Maximum Drawdown):

The Sleep Easy Portfolio: -1.63% (-4.27%)
All-stock portfolio (SPY): -19.43% (-19.43%)
60/40 portfolio (SPY and AGG): -10.42% (-11.12%)

While it’s never fun to lose money over a three month period, being down less than 2% during a historic market drop, while remaining fully invested in the market, is a pretty comforting result. Remember, a key part of the rationale for The Sleep Easy Portfolio is removing the temptation to time the market or make active decisions on when to jump in and out of stocks. The Sleep Easy Portfolio uses fixed percentages of the four ETFs that are set to “autopilot” requiring no additional tactical moves, aside from occasional rebalancing.

While the performance of the all-stock portfolio is expectedly poor during such a harsh bear market, the 60/40 portfolio’s performance was also somewhat disappointing, with a double digit negative return and drawdown. We used the popular bond ETF AGG to represent the 40% bond portion, because it’s based on the most common bond index that most investors would use for this type of portfolio. Because AGG contains corporate and mortgage bonds, both of which suffered to some degree during the early days of the market crash alongside stocks, investors in a typical 60/40 portfolio didn’t receive the same downside protection and negative correlation to stocks as they would have from The Sleep Easy Portfolio, which relies exclusively on long-term treasury bonds, one of the stand-out positive asset classes during the market crash.

What Explains The Sleep Easy Portfolio’s Relative Outperformance Compared to the Other Portfolios?

In brief: TLT. Long-term treasury bonds continued to exhibit negative correlation to stocks when investors most needed it. Just as they did in 2008, long-term treasury bonds put up significant positive returns each month of the quarter, including when stocks cratered in March. The returns didn’t quite make up for the losses in stocks (particularly the 10% allocation to emerging markets stocks, which were hammered even harder than SPY), but they did provide a significant cushion to the portfolio. TLT also benefited from aggressive rate cutting from the Fed during this period (the value of long-term treasury bonds increase as interest rates decline).

What Parts of The Sleep Easy Portfolio Disappointed?

Although a small part of the portfolio, gold did not perform as well as might be expected in a market crash environment driven by a scary external shock, such as a pandemic. After producing a solid 4.5% gain in the month of January, GLD posted small losses of under 1% in both February and March. Many analysts speculated that gold fell victim to “forced selling” when investors needed to utilize cash from a positively performing asset class to cover stock losses, or simply that investors moved their portfolios entirely to cash in a panic. Other theories point to disruptions in the physical gold exchanges causing price disruptions as a result of the pandemic

While gold did not hold up as well as we might have wanted in Q1, it has since rallied, posting a 10% return over the past 30 days covering the end of March through April. As the Fed embarks on another round of extraordinary actions to prop up the financial system, the outlook for gold potentially remains positive, as the yellow metal typically benefits in an environment where other assets such as bonds offer little yield. Gold’s biggest detraction is that because it is a phyical asset it does not produce a yield like a bond or dividend paying stock would, but in an environment of near 0% bond yields and aggressive dividend cuts, gold looks relatively attractive by comparison. Some also see gold benefiting from the long-term impact of historically high debt and a US dollar printing press turned to overdrive.

In addition to gold, long-term treasuries, while performing well overall, also had some unexpected blips during the height of the market panic. Credit markets again experienced liquidity issues and there were a number of days when even “safe” bonds sold off. Some have pointed to issues with the stability of bond ETFs and others highlighted concerns around the functioning of markets more broadly, particularly embodied by the struggles of the repo market. These few days of dislocation detracted from TLT’s ability to fully perform and counteract the significant losses on the stock side of the portfolio, but viewed over the course of the three months, those who held TLT are likely grateful for it, even with a few bumps in the road.

Finally, DGS, the emerging markets ETF, experienced pretty epic losses in line with the broader emerging markets asset class. It’s hard to classify this as a disappointment though, as we know that emerging markets are the riskiest asset class in The Sleep Easy Portfolio and would be expected to bear the brunt of the pain during a global market sell-off. This is also why the fund is limited to only 10% of our portfolio.

What’s the Outlook for The Sleep Easy Portfolio for the Remainder of 2020?

We don’t have a crystal ball and that’s the point of The Sleep Easy Portfolio. This asset allocation should perform reasonably well in any market environment.

If the global economy fully recovers and we experience a V-shaped recovery, the 50% of the portfolio dedicated to riskier stocks should exhibit some strong gains, likely to more than offset some of the losses we might expect in TLT and GLD as investors rebalance out of safe haven asset classes.

But because of the aforementioned Fed actions, we can also envision an environment where gold rises in tandem with stocks during a recovery.

If the recent stock market rally proves to be shot-lived and we retest the lows, more shallow losses such as the portfolio experienced in Q1 are possible, with TLT and potentially GLD continuing to outperform stocks and provide some cushion.

While no losses are pleasant, avoiding huge losses is a key to long-term investing success. A 25% loss in your overall portfolio requires a 33% gain just to get back to even.

The asset allocation that The Sleep Easy Portfolio is based on has never experienced a double digit annual loss going back to the late 1970s, making it worthy of risk-averse investors’ attention. Its performance during this recent market sell-off has only reinforced the merits of a sound asset allocation for long-term investing success.