Overall, we’re cautiously optimistic about the recovery domestically, with an eye toward the various external macro forces that could disrupt it. As you know, we believe true diversification is a proactive process that requires looking under the surface of stated asset class objectives to identify underlying performance drivers and risks that could pervade multiple asset classes.

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In financial markets, equilibrium is a constantly moving target; the textbook “steady state” or “balance” doesn’t exist in an open and global economy. Some external shock is introduced and markets adjust to find the new balance between supply and demand for different assets.

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The renewed strength that the US economy began to show late last year has translated into a number of opportunities in credit and equities domestically. On the credit side, our managers are tilting away from richer high yield and treasury bonds in favor of mortgage-backed securities and high quality corporate bonds.

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It is not enough to take a narrow look at “Greece” or “Europe” exposure without exploring the various risk factors and knock-on effects associated with it – it’s impact on liquidity, volatility, growth and so on. One of the more likely secondary effects the European crisis will be on certain emerging markets investments.

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At Rain, we decompose strategies by risk factors. We deliberately select strategies on the defensive end of portfolios that are diversified by those risk factors. We use tools on the bond side that allow for far greater flexibility to manage exposure to interest rate and credit spread risk as well as non-fixed-income-centric strategies whose returns are largely independent of interest rate risk and safe-haven volatility. This allows us to build more dependable and truly diversified qualities into the defensive side of client portfolios.

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There is always a trade-off between the return sacrifice and diversification benefit a strategy brings to a portfolio. Long-dated bonds and treasuries in particular, have demonstrated strong diversification benefits in portfolio construction because of their negative correlation to other asset classes, like equities.

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Widely accepted ways of measuring risk simply do a poor job of showing it. Risk encompasses the multitude of scenarios an investment could deliver, not the single path that ends up being measured afterward. In other words, volatility, standard deviation (and the many ways they are sliced and diced in risk management models) tells us what has happened, not what might have happened or could happen in the future.

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Bonds are the parachutes of the investment world; they have offered safe, stable income and their prices generally go up when everything else goes down, giving them a nice defensive quality in portfolios. Falling interest rates are the wind that keeps the parachute open and the greater the duration (interest rate sensitivity), the softer the landing.

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Bonds are exposed to interest rate risk and the greater a bond’s duration, the greater the sensitivity to that risk. Perhaps more importantly given the current interest rate environment, the more rates fall, the more that risk rises exponentially.

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