Morgan Stanley’s Top Three Portfolio-Diversifying Trades

You never know what’s around the corner in uncertain times like these, and that’s especially true for stocks’ performance. With that in mind, you might do well to diversify your portfolio – no matter whether you want to find a cheap way to protect your favorite stocks or want to make money from a bearish view. So with a little help from Morgan Stanley, here’s a framework that can help you find investments fit to hold strong when stocks struggle.

How do you know if an asset would diversify a portfolio well?

Most investors’ portfolios are dominated by stocks, so for the sake of diversification, you might want to hold assets that can perform well when stocks aren’t keeping their end of the bargain. There are plenty of options, so you should ask yourself the following five questions to weed out the opportunities with the most potential to successfully diversify:

Does it diversify? You need to make sure the asset doesn’t behave like stocks. Ideally, you’d use an asset that’s inversely related to stocks, meaning it performs well when stocks are performing poorly.

Can it diversify consistently? The asset’s low or inverse correlation to stocks can’t just crop up once in a while, mind you. You’ll need to make sure it’s been stable over time and is proven to work in a lot of different scenarios.

How well does it perform? Like with any investment, you want to spot the star performers. You’ll be able to find a batch of decent diversifiers, sure, but make sure you check out how well they perform when stocks are having a bad time.

Is it cheap? The cheaper the asset is, the less likely it is to experience a sharp reversal and the more likely it is to grind higher.

How expensive is it? Buying a hedge is like buying insurance. And while insurance always comes with a cost, you’ll need to make sure you don’t overpay for it.

The first three of those points can help you spot a well-rounded diversifier, while the latter two help you find one that’s decently priced. Of course, it’ll be very difficult to find an asset that scores highly on all five factors, so there are always trade-offs involved. For example, shorting the S&P500 is likely to be a very reliable and effective diversifier for your portfolio – but chances are, it’ll be prohibitively expensive to execute. So that tactic could perform well if markets crash, sure, but you’d lose a lot of money if they don’t. (After all, not only would you lose out from its price rising over time, but you’d also have to pay dividends if you’re short). Remember, then, that the best diversifying trades are the ones that are not only efficient, but also attractively priced.

Now, it’s important to note that those components are dynamic, meaning different assets will be more effective at different times. Take bonds, for one: they diversified stocks extremely well over the past decade – but that stopped last year when both stocks and bonds were hit by high inflation. So when you’re comparing potential hedges, look for one that’s likely to work well in today’s environment.

How do you rank potential hedges?

Morgan Stanley has a handy method for scoring and ranking different assets as potential diversifiers. The big bank identified specific desirable features, and selected metrics to measure each one. For each metric, the asset will receive a score from 0 (bad diversifier) to 100 (great diversifier).

The first three measures estimate how reliable the asset is likely to be as a diversifier:

To assess whether an asset can diversify, calculate its correlation to global stocks.

Correlation measures how closely two assets move together. It ranges from -1 (they move in opposite directions) to +1 (they’re in perfect sync), with zero meaning they have no relationship at all. The lower the correlation to stocks, the better the diversification benefits – and as a result, the higher the asset will score on that metric.

To assess how consistently it can diversify, calculate the stability of its correlation over time.

The more stable a correlation is, the more likely the asset is to diversify in different scenarios. To assess stability, Morgan Stanley compares how high (when the correlation was in the top 5% of its historical range) and how low (when the correlation was in the bottom 5% of its historical range) the correlation has been. The tighter the range between the two, the more stable the relationship is, and the higher the score it’ll receive.

To assess how well it’s likely to work, calculate the downside beta to global stocks.

Beta might sound complex, but it’s really just a measure of how one asset relates to another. It captures not just the correlation, but also the magnitude of the moves. So the higher the correlation and the more it moves relative to the other asset, the higher beta. Now, we’re interested in understanding how an asset performs when stocks are in a slump, so Morgan Stanley looks at the “downside beta” – that’s the beta calculated during periods when stocks only go down. The better an asset performs when stocks go down, the higher its score.

The following two measures capture whether or not you’re paying an attractive price for the diversifier:

To work out if it’s cheap, calculate its valuation versus its history.

The lower an asset’s valuation, the more likely it is to slowly climb higher over time and the less likely it is to see a reversal. Since it’s hard to compare the valuations of different asset classes, Morgan Stanley looks at how cheap the asset is relative to its own history. (In terms of valuation measures, it uses the price-to-book ratio for stocks, real exchange rates for the foreign exchange market, real yields for bonds, loss-adjusted spread for credit, and inflation-adjusted prices for commodities.) The cheaper the valuation is relative to its history, the higher the score.

To calculate costs, look at the asset’s carry versus its history.

Carry is your cost of insurance, essentially how much you can expect to pay if prices stay the same. Like with valuations, Morgan Stanley prefers to look at how cheap implementing the hedge is versus its own history. The lower the cost today versus its history, the better the score.

Morgan Stanley then adds all those scores up to find a final score, giving 60% weighting to the first three measures (how reliable the hedge is) and 40% to the latter two (how attractively priced the hedge is). The bank recalculates those scores each month, providing a monthly list of the most attractive diversifying trades for your portfolio.

What trades would Morgan Stanley pick out right now?

Best diversifying trades according to Morgan Stanley's framework. Source: Morgan Stanley

Option one: go long on consumer staples stocks and short the market.

Consumer staples companies make and sell essential goods that folks every single day, like food and beverages, personal care products, healthcare items, and tobacco products. And because shoppers tend to buy those products no matter what’s happening in the economy, the firms can work as defensive plays. So by buying these companies and shorting the market, you’re essentially betting that defensive companies will outperform other ones, which is likely to happen if the economy’s slowing or the stock market tanks.

Looking at the individual metrics, this trade seems to be a reliable diversifier: it boasts a high correlation score (meaning it moves inversely to stocks), a stable correlation (meaning it’s more likely to work well in the future), and a high downside beta (meaning it does well when stocks do badly). But as for its overall valuation score, it’s nothing special. Still, this trade ranks first according to the framework overall, and should be a solid trade to implement if you want to protect your portfolio against an economic slowdown.

You can execute the trade by using the Consumer Staples Select Sector SPDR exchange-traded fund (ETF) (ticker: XLP, expense ratio: 0.10%) and short the SPDR S&P500 ETF (ticker: SPY, expense ratio: 0.10%). Shorting the ETF directly is your best option, but if can’t do that, you can buy the ProShares Short S&P500 (ticker: SH, expense ratio: 0.88%) or use a contract-for-difference (CFD).

Option two: short oil

A strong economy tends to push up demand for oil, and the price of the slippery stuff usually rises as a result. So shorting brent – one of two major oil benchmarks – is essentially a bet that the economy will slow down. And because oil prices tend to move significantly, the trade could provide a high-octane hedge if sentiment turns sour. This is confirmed by Morgan Stanley’s framework: shorting brent has the highest overall correlation score, indicating that it should be extremely efficient at hedging a potential drawdown in stocks. However, its valuation is only mildly attractive, and it has the worst cost of carry – meaning keeping the trade on would be very expensive. You need to get the timing right, in that case, as you’re likely to lose money if nothing happens. So overall, this is a handy trade if you’re looking for a pumped-up hedge to protect against an imminent correction in stocks, but probably not your best bet if you prefer to hold over the medium term.

To implement the trade, you can short the United States Brent Oil Fund LP (ticker: BNO, expense ratio: 1.02%) or bet against it via a CFD. If you’re looking for a very short-term hedge (say, protecting against a market crash over the next few days), the ProShares UltraShort Bloomberg Crude Oil (ticker: SCO, expenses ratio: 0.95%) might be an option. But since it’s a leveraged short ETF, you should only put it on if you’re an advanced investor and plan to hold it over a few days.

Option three: long real estate stocks and short the market

Real estate tends to be a cyclical sector, so it’s far from surprising that the trade has relatively poor correlation scores and may not work reliably if stock markets tank. But since real estate stocks have corrected a lot already, the sector’s now scoring very positively when it comes to valuation. What’s more, it also ranks extremely positively in terms of carry. Overall, it essentially has the opposite hedging properties of the short brent trade, so it could be a savvy bet for investors looking to implement a longer-term hedge or bet on a softer landing.

You can implement the trade using the Real Estate Select Sector SPDR ETF (ticker: XLRE, expense ratio: 0.10% ) and short the S&P using the same methodology as in the consumer staples example.

What else looks attractive?

Long utilities and short the market: This trade doesn’t tend to shoot the lights out when stocks go down (i.e. its downside beta is not so high). But that said, it’s got an attractively low and stable correlation to stocks, and isn’t scoring too badly in terms of valuation either.

Long industrials and short the market: This trade may not be the most reliable (the industrials sector tends to be cyclical, much like real estate), but it scores extremely well in terms of valuation and cost of carry.

Long emerging market stocks and short US ones: Scoring highly in terms of valuation, this trade is a bit like the real estate versus market one since it doesn’t score as highly in terms of correlations.

Short the Australian dollar versus the US dollar: This might be the most underrated hedge out there as it ranks highly on almost everything except valuation. It’s arguably a great trade to protect against some downside risks, and could be a smart addition to the top three trades recommended above.

So how do you actually use this framework?

The best way to go about this technique is to implement the top three to five trades recommended by the framework. By diversifying across different hedges, you can maximize your chances that it’ll work well during crunch time. For those that don’t want to (or can’t) short, reducing some of your stock exposure and rotating into the more defensive trades proposed may already help reduce the risk in your portfolio.

Of course, you can also pick out the trades that best fit your market views. If you want to add longer-term diversification to your portfolio at the cheapest possible price, you might want to consider buying real estate stocks, utilities, industrial sectors, or emerging market stocks. Or if you want to protect your portfolio against an imminent market crash, buying consumer staples stocks and shorting the market, shorting brent, and shorting the Australian dollar versus the US dollar may be your best bets.

Now, there’s no guarantee that any of those hedges will always work. They should, however, get you thinking about how you could hedge your portfolio with assets other than bonds. And since Morgan Stanley uses a transparent, rule-based technique, you can apply the same framework to hedge any other risk you have on your radar.