The groans of despair heard from multi-asset portfolio managers lament the positive correlation between equities and bonds we have seen this year and the consequent loss of portfolio diversification.
It is true that correlations have been unusually high, nearing 100% (see Exhibit 1). However, in a sense, complaints about highly positive correlations mischaracterise the problem. High correlations are not unprecedented; in the 1980s and 1990s, they were frequently above 80%.
What is distressing about the current environment is that correlations are high while the returns of both equities and fixed income are negative. Previously, they were positive. One heard fewer complaints about positive correlations in the 1980s and 1990s.
In fact, the issue is not even the negative returns for equities. The US Federal Reserve has been raising interest rates and most investors now worry about recession, so negative returns are not at all surprising. What is unusual is US investment-grade fixed income. This asset class has seen the longest, most negative streak of returns since the inception of the Bloomberg Barclays US Aggregate index. The return over the last 12 months has been -14%, with each and every month showing negative year-on-year returns. The previous worst episode was in 1980 (-9.2% year-on-year return), and the string of negative returns then lasted just three months.
What we have had this year is the often-predicted end of the fixed income bull market of the last 50+ years. Were it not for the coronavirus pandemic and the Ukraine war, inflation may have remained quiescent and interest rates low, but central banks now need to slay the inflation dragon.
60/40: Fit for purpose?
Do the poor returns of a typical 60% equity, 40% fixed income balanced portfolio this year mean that it is no longer fit for purpose? Such a simple asset allocation does not reflect how institutional investors actually construct portfolios. Our own recommendations include allocations not just to currencies via cash allocations, but also to alternative assets such as real estate, convertible bonds and commodities. We have published research recently on incorporating thematic investments in portfolios, and private debt and private equity are playing an increasing role.
Nonetheless, the allocation to equities and bonds accounts for the bulk of most portfolios and is critical to the risk-adjusted return. The default 60-40 percentages are just a rule of thumb, but the allocation has historically provided a positive return and a high Sharpe ratio (see Exhibit 2).
Inevitably, the performance of this portfolio varies over time depending on growth and interest rates. This year’s performance has been poor, but investors can take some comfort in knowing there have been worse periods (see Exhibit 3).
The question is whether this is just another brief period of subpar performance or whether the relationship between, or outlook for, equities and bonds has shifted fundamentally and now requires a permanently different asset allocation.
We believe it is the former. Real yields have recovered significantly over the last year and are now back to their post-Global Financial Crisis (GFC) highs (see Exhibit 4). This is still below the pre-GFC level and one can debate what the long-run rate will turn out to be. As central banks slowly unwind their balance sheets – only the Fed has started this process – rates will likely rise, but we believe this will take place gradually over the next decade in contrast to the brutal adjustment we have seen this year. Moreover, central bank balance sheets may never return to pre-GFC levels and growth rates are lower, suggesting real rates may never fully revert.
We anticipate nominal bond yields moving in a 3-4% range in the years ahead (outside of recessionary periods), alongside a return of the historical correlation between equities and bonds.
This year of transition has certainly been challenging, requiring lower allocations to equities and bonds and higher ones to alternatives and currencies. However, one should not throw out the baby with the bath water. A well-diversified portfolio, with traditional allocations to equities and bonds, will likely still provide institutional investors with the best risk-adjusted returns.
Constructing a diversified portfolio
For a defined benefit (DB) pension fund, we believe a 60% equity-40% bond portfolio is certainly too simple. The idea is rather to have roughly 60% equity-like risk and 40% liability duration-like risk in the portfolio. Within these buckets, there is plenty of scope to diversify the exposure further. For the actual construction of the portfolio, mean-variance, with all its limitations, is often still the default. One of the big shortcomings remains the sensitivity of the optimal portfolio to small perturbations in the input. Robust optimisation can address this shortcoming by taking into account the uncertainty in the expected return. ‘A Practical Guide to Robust Portfolio Optimization’ by our Quantitative Research Group discusses the approach in detail. The key point we want to make here is that a well-diversified portfolio starts with a good methodology for portfolio construction.
The allocation to a portfolio with roughly 60% equity-like and 40% liability duration-like risk can fluctuate over time (see Exhibit 5). Such a portfolio has the same risk profile as a 60/40 portfolio, but with some leeway to deviate from a strict 60/40 split. The construction process uses robust optimisation as mentioned above with the rolling five-year historical risk and return numbers as an input.
Diversification is traditionally expressed in terms of exposure to different asset classes, regions and investment styles. Investments in private assets can strengthen the diversification credentials of a portfolio further: they can enhance returns by earning an illiquidity premium, and reduce risk through diversification and less exposure to the short-term volatility of public markets. In this respect, private assets are expected to play an increasingly important role in sustainable investing.
Investing in private assets comes with challenges. Private asset funds tend to have minimum investment sizes, which are often excessive for smaller investors. Even if they could, investing in private asset funds is not as simple as investing in public asset classes. Because of the illiquid nature of private assets, investors are required to commit capital for a number of years. Because not all committed capital is put to work immediately, investors need to manage the cash flows associated with the capital calls and distributions from the allocation to a private asset fund over time. Managers of private asset funds tend to make capital calls in the first years of the lifecycle of the fund as they find suitable investments. Similarly, they tend to distribute capital as investments mature and are disposed of.
An additional difficulty is that the returns realised on the total capital committed to one single private asset fund can be lower than the reported internal rates of return (IRRs) because of the dilution effect. Indeed, while the IRR reported by private asset managers tends to look attractive, not all committed capital is put to work immediately or for the entire locked-up period. A strategy to manage cash flows and investing in multiple private asset funds with maturities spread over time is required to be able to realise attractive returns on the capital committed to these investments.
‘Allocation to private assets in open-ended funds’ proposes, for example, a strategy structured around an open-ended fund, which invests in private and public asset classes. To realise returns close to the IRRs reported by private asset funds, the strategy commits new capital every year to the newest vintages of private assets funds and manages the calls and distributions adequately over time. The strategy estimates the optimal amount of capital that should be committed every year to the new vintages so that the portfolio allocation to capital at work in all private asset funds, i.e. deployed by the private asset managers, remains constant over time and at the pre-determined target allocation. To estimate how much capital should be committed every year, the strategy uses the expected calls and distributions from the different vintages of private asset funds in the portfolio as well as the expected IRR of the funds and the expected returns for public asset classes.
This approach can make a portfolio’s positioning more forward-looking. Themes are structural rends expected to significantly affect economies and redefine business models. Thus, it is natural to expect themes to play a role in explaining the returns and risks of investments with greater exposure to those structural trends. However, not all themes matter equally, and thematic investing offers more than just a single compelling opportunity. Thematic investing aims to identify assets whose returns are impacted by the structural changes underlying the theme. These changes come about through megatrends that shape societies: demographic shifts, social or attitudinal changes, environmental impacts, resource scarcity, economic imbalances, transfer of power, technological advances and regulatory or political changes. Thematic investing aims to transform one such megatrend into a relevant investment opportunity.
Construction of a well-diversified portfolio is not just a matter of blindly tapping into various sources of returns that have shown a low historical correlation. Ultimately, a portfolio needs to be well positioned to reap the benefits of future opportunities. The key phrase is ‘forward-looking’, i.e., the portfolio’s positioning needs to be forward-looking. This is more easily said than done.
Allocating to themes requires discipline because thematic investments are not only exposed to the theme, but also to traditional risk factors. Our research paper ‘Allocating to thematic investments’ discusses a framework based on robust portfolio optimisation which accounts for the expected excess return from the exposure to the theme and from exposures to traditional risk factors. This framework offers a solid solution to the problem of allocating to both traditional assets and thematic investments in a given portfolio. The paper illustrates the implementation of the framework with an example that goes beyond allocating only to equities, but also to fixed income thematic investments.
Even well designed portfolios are not immune to substantial price swings. To weather market storms, investors can turn to portfolio protection strategies. These tend to affect long-term return expectations negatively. However, their dynamic features can help minimise opportunity costs and may even lead to better risk-adjusted portfolio returns.
Protections strategies come typically in two flavours: option-based or future-based. Future-based strategies dynamically protect portfolios by reducing the exposure to risky assets the closer the value of the portfolio drops to a predefined floor. Option-based strategies can be implemented as both one-offs and dynamically, where the protection structure is regularly rolled into a new contract. They can be applied to only the equity or risk parts of the portfolio or to the total portfolio. Our research paper ‘Equity risk overlays’ describes the various possibilities in detail.
 Allocating to Thematic Investments, Financial Analysts Journal