Traditionally, bonds have been seen as effective diversifiers against a portfolio of equities. This was particularly true through the secular bull market in bonds that began in the early 1980s. Through the 1980s and 1990s, business cycles tended to be smoother and recessions were generally shallower and less frequent. But in times of extreme market volatility, such as the bursting of the tech bubble and the global financial crisis, bonds and equities maintained a negative correlation. Unfortunately this did not provide sufficient overall portfolio returns for plan sponsors: equity drawdowns were significant and bonds provided only a modest positive return.
The recent global financial crisis has led to a prolonged period of zero or near-zero interest rates and successive rounds of quantitative easing. This has created an environment where bonds are unlikely to muster sufficient returns to protect portfolios during future significant market downturns. Additionally, there has been evidence since 2012 that the correlation between these two assets has persisted in positive territory, challenging traditional asset allocation during times such as the “taper tantrum” in 2013.
At the same time, in the current policy environment, asset allocations that rely on historical diversification between stocks and bonds might fall short of overall rate of return assumptions. Additionally, other traditional diversifiers such as investments in oil, the U.S. dollar, gold, or even a broad basket of commodities, have become increasingly correlated to the returns of global equities in the current age of quantitative easing.
In this environment, investors are challenged to find a traditional asset class that may consistently provide a good hedge against equity risks. This raises the question of how to mitigate losses when all major asset classes are declining simultaneously.
Better diversification may instead be achieved by tearing away traditional asset class labels and focusing on investing in ideas instead.
When you strip away labels and focus on good investment ideas, you can isolate specific economic drivers or fundamentals which may produce a return stream that is independent of the direction of broader equity and fixed income market returns. Multi-asset portfolio managers may look to assets such as volatility instruments, inflation products, currencies and commodities in addition to traditional equity and bond investments. By using a wider range of asset types and instruments, investors can implement ideas focused on macroeconomic trends rather than the direction of financial markets.
The starting point for this framework has to be an unconstrained research approach, which eliminates any notion of a “neutral” portfolio, such as a traditional 60/40 split, which can constrain the ability to achieve maximum diversification of investments.
This approach is best achieved through a two-step idea process:
Step 1: Determine a good long-term investment idea that is macro driven.
Step 2: Select the right asset type across global liquid markets and instrument to represent that idea. The goal is to capture the best representation of the idea in risk/return space.
Case study
Take, for example, the difference in how the market is pricing the volatility of the Australian dollar and that of the U.S. dollar. There are several macro drivers of this investment idea. Australia is heavily dependent on China as a trade partner. It is also a much more cyclical economy than the U.S., and Australian economic growth has been more volatile and generally higher than that of the U.S. This is to be expected given that Australia is commodity driven, more levered, has a housing market that hasn’t cracked, and is essentially the service sector economy for Asia as opposed to the domestically oriented U.S. economy.
While one might expect the volatility of the Australian dollar to be materially higher than that of the U.S. dollar, the reality is that in the recent, subdued market environment the volatility is very similar. To implement this idea, investors can use volatility swaps to exploit the belief that the Australian dollar should become more volatile than the U.S. dollar.
In conclusion, the concept of investing in ideas is not intended to replace a traditional broad-market strategy but to complement it. Combining both into a single portfolio could provide enough diversified growth to protect against an everchanging investment landscape.
Given that the traditional mix of assets may not provide enough of a hedge during strong equity market drawdowns, it is important to achieve a level of diversified growth that can help an overall portfolio, independent of broader market returns.
Danielle Singer is Senior Client Portfolio Manager, Multi-Asset Strategies, Invesco