VALUATION MATTERS: RISK-ADJUSTED RETURN PERFORMANCE: U.S. HIGH YIELD TRUMPS S&P 500; USING LEVERAGE TO ENGINEER SUPERIOR RETURNS GIVEN RISK CONSTRAINT

The S&P 500 has rallied almost 40% from the March 9, 2009 lows. U.S. HY (HYG) and U.S. IG (LQD) are up 28% and 8%, respectively.

Yet, risk adjusted performance tells a different story. And that is what really matters because any asset class/security can be levered up/down to provide the desired risk-return characteristics. Clearly, the investment with the highest ratio of mean to standard deviation would dominate in this framework.

Based on this criteria(see Figure 1), U.S. High Yield performed the best in the rally since March 9, 2009, followed by equities and U.S. IG.

Assuming that we could borrow at 10%(see Figure 1), it was possible to engineer a portfolio that would have outperformed stocks while commanding the same risk defined in terms of standard deviation.

The key message of the story is that valuation matters. At the March 9 lows, stocks were modestly undervalued, but U.S. High-Yield looked battered and offered better potential risk-reward characteristics.

Figure 1