Managing risk diversification as the 60/40 rule breaks down
The changing correlation between bonds and equities creates new challenges for diversifying risk. Chris Hall reports.
“If you had tried to predict the 1970s and 1980s based on data from the previous three decades, you’d have been badly wrong.” This is how Wayne Fitzgibbon, a partner at institutional investment advisor Mercer, applies the maxim about past performance being no guarantee of future results to challenges besetting money managers in periods of extreme turbulence and disruption.
The upheavals sparked by Richard Nixon’s 1971 withdrawal from the Bretton Woods system of fixed exchange rates led eventually to a new regime of largely unfettered capital flows and free-floating currencies. Inflation was gradually tamed, whilst debt levels and asset prices rocketed. Similarly, Fitzgibbon characterises the past decade as a transitional ‘not normal’ phase, punctuated by some dramatic shifts, on the way to a ‘new normal’, not yet fully formed.
“We’re on the cusp of a new normal. Many factors will shape the new regime: from geo-politics and trade to climate change and demographic trends,” he says.
Fitzgibbon sees a shift toward stakeholder capitalism, with profits and revenues joined by metrics reflecting impact on, and contribution to, wider society. But high levels of unpredictability about the new normal mean the recent past will offer little insight.
“Correlations between assets will change, but we’re not convinced that any statistical analysis of correlations using data from the last ten years, or if you throw the last two decades together, will be a good guide to the future,” he says.
Central bank as elephant in the room
One factor that made the 2010s decidedly not normal was monetary policy in major western economies. Aimed at stimulating lacklustre post-crisis GDP growth, low-to-negative interest rates, quantitative easing (QE) and bond-buying programmes undermined the highly negative correlations between bonds and equities on which many investment strategies were built, especially among balanced or multi-asset funds.
“Central banks have taken an increasingly active role in the markets, suppressing volatility with regular injections of liquidity. The rising tide has lifted all boats,” says Marc Franklin, head of flexible multi asset at NN Investment Partners. Long-established bond/equity correlations, have become less pronounced and less predictable, shifting from strongly negative to both mildly positive and mildly negative in recent years.
In the new decade, central bank policy is still focused on stimulating growth, but retreat from QE is now openly discussed, if not yet fully in motion. If equity valuations tumble without central bank support, low-to-negative yielding government bonds won’t come to the investor’s rescue. In or after a period of transition, higher bond yields and negative correlations could return, but that might not save any funds persisting with a 60/40 asset allocation split between equities and bonds.
In the league tables, balanced and other multi-asset funds have been outshone by simpler strategies in a prolonged, if artificial, bull market. Fitzgibbon argues for adjustment not abandonment. “Diversification was not needed in the past decade. But you don’t stop buying house insurance just because your house hasn’t burned down,” he notes.
The likely combination of heightened volatility and unstable correlations means portfolio managers must develop strategic frameworks that allow for tactical flexibility. In the first instance, this means finding a substitute or complement for bonds in terms of risk diversification, albeit respecting performance targets and risk constraints.
This could lead to 20% of strategic asset allocation directed to non-correlated asset classes such as real estate or insurance-linked securities such as catastrophe bonds, suggests Mathieu L’Hoir, senior multi-asset portfolio manager at AXA Investment Managers. These assets are less liquid than listed securities and require a wider range of analytics skills and tools, as well as different trust and custody arrangements, adding to cost.
As such, other approaches are also needed. Traditionally, multi-asset portfolio managers tend to hedge non-domestic fixed-income exposures and keep equity investments unhedged. In volatile conditions, this means a 60% allocation to equities, for example, implicitly carries even higher risk. Keeping all US$-based investments unhedged in unpredictable markets, due to the tendency of the greenback to rise when equities tank, can supplement diversification.
“A manager with 30% or more allocated in equities and around 50% in global high yield or hard currency emerging market bonds, might be better off not hedging their US$ exposure,” he says.
To boost tactical flexibility, L’Hoir suggests actively trading volatility. Noting the high cost of buying put options from banks, he says a similar effect can be achieved at lower cost by replacing equity exposures with the simultaneous buying of call options and selling of futures to create a ‘strategic put’. With this approach, the call position will mechanically increase the fund’s exposure as the market goes up, offering the opportunity to sell futures to take the profit. Dynamic management of positions is crucial to the fund’s efforts to optimise gains and mitigate costs, L’Hoir adds.
Franklin agrees on the need for tactical ‘nous’ within a flexible strategic framework. He adds that the precise approach should depend on whether the fund’s prime focus is protection or diversification. If the former, it may be sufficient to play defensive, leveraging the resilience of government bonds. If the latter, it’s necessary to look beyond the core, perhaps to precious metals and high quality corporate bonds, particularly those offering long duration.
To generate and execute ideas across the full range of asset classes and markets, Franklin adds, funds must have access to deep human and technical resources. “The big are getting bigger. To ensure diversity of ideas within the portfolio you need a breadth of skillsets.”
If correlations and diversification cannot be relied upon in public markets, Fitzgibbon suggests private market assets, notably infrastructure. As well as privatised assets, such as railways and airports, this now encompasses green infrastructure, including desalination plants, sea walls, carbon capture capabilities, and power grids.
These are not subject to the liquidity challenges increasingly facing publicly-traded asset securities, although they can be framed by lock-in periods and fees that reflect the due diligence required for physical assets. Investors can tap private infrastructure via funds of funds, and specialist private equity funds, as well as through multi-asset funds, although charging structures will vary.
Despite acknowledging the seismic shifts in the geo-political and macro-economic background, Liontrust’s head of multi-asset, John Husselbee, is reluctant to call time on bonds. He also argues diversification beyond 60/40 has long been a feature of the multi-asset spectrum, especially in the retail market.
“Bonds still offer investors over the medium to long term a yield, diversification to equities, capital preservation and in some cases inflation protection. We seek further diversification from non-traditional asset classes such as absolute return funds, hedge funds and commodities,” he explains. “Whilst we are not prepared to time the markets, we do see merit in tilting portfolios more defensively when valuations seem to be expensive and vice versa.”
Shifts in correlations between asset classes should be monitored, Husselbee suggests, but only as a factor within a wider process. “Consistency of performance is impossible but consistency of process is a prerequisite and can ultimately lead to long-term excess returns. Investors should be aware of the importance of blending styles to get the full benefits of diversification,” he says.
Tactics will vary, but a robust process and steady nerve will be needed to prepare portfolios for regime change as central banks pull back from the QE era. “2018 was a foretaste of challenges to come,” say’s L’Hoir, noting the bouts of volatility prompted by concerns over QE withdrawal. “There could be nowhere to hide.” ●
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