(ATF) We are facing an asset allocation conundrum insofar as the tools we as portfolio managers once used may not give us the diversification benefits or performance attributes we once enjoyed.
Reports of the demise of government bonds as a diversifier may have been exaggerated, but even after, and perhaps because of, the recent rise in Government bond yields, their likely impact within a return-seeking portfolio is under increased scrutiny. This, coupled with an equity market rebound which has seen historically high market valuations, forces us to consider alternative return generators and diversifiers.
In recent years, a 60/40 portfolio construct has proven to be a very hard benchmark to beat. For example, over the last 10 years it has delivered an excess return of 7.6% over cash, with a volatility of 7.5% delivering an excess return/volatility (i.e. Sharpe ratio) of 1.0 – an exceptional result as any textbook would attest.*
However, the changing environment means we need to assess additive investments and in doing so we split our search for building blocks into two camps: enhanced diversifiers which offer some form of left-tail protection, but with limited cost. Secondly, alternative growth strategies which ideally access alternative risk premia or offer some degree of asymmetry. The list of building blocks for the alternative growth bucket is potentially large. Below, we share a few examples.
- Concentrated government bond baskets
Barring a big rise in inflation or an un-anchoring of inflation expectations, the negative correlation between equities and bonds will probably hold. In that sense, government bonds have not lost their allure and still have a role in helping to diversify holdings in more risky assets without the negative costs often associated with other hedges. Hence, with the aim of maximising diversification benefits, we build a framework where government bond holdings are based on a country and bond specific assessment of their likely performance in periods of stress rather than simply holding traditional index weightings. We look at government bond markets with an eye to what carry they currently offer and what support they might offer in a stressed risk asset environment.
- Equity protection strategies
Equity put protection
There are many ways of making money when risk assets fall, for example buying equity market puts. Over the longer run, however, this tends to be very expensive if implemented on a systematic basis.
Multi-leg equity protection strategies
Selling out of the money puts or calls can cheapen a protection strategy at the cost of limiting the upside. There may be occasions where such a trade makes sense if fundamentally an investor feels downside risks are capped, for example by an aggressive policy response to a large equity market sell-off. Similarly, there may be occasions where taking on ‘right tail risk’ (i.e. losing money if equity markets rise) is an acceptable strategy when viewed in a broader portfolio context.
Synthetic equity protection strategies
It is possible to synthetically replicate a profile similar to that of a long call. By increasing exposure to an asset when it is performing, and reducing exposure when it underperforms, a convex profile can be created. This can be done by trading index futures, rather than buying options. The use of synthetic option replication is less suited to benchmark orientated 60/40 style portfolios, but they can still be a useful building block.
Alternative growth strategies
- Convertible bonds
Convertible bonds offer return-orientated investments with, to some degree, a non-linear return profile that can help improve overall portfolio risk/ return dynamics. They have the benefit of giving upside exposure to the equity market during bull markets, while still maintaining the lesser drawdown characteristics of bonds in bear markets.
In theory, investing in infrastructure is perceived to offer two key positives – stable long-term returns and diversification benefits versus equity risk, both attractive attributes for a multi-asset investor. In reality, however, many global listed infrastructure indices have a high economic sensitivity and demonstrate a close relationship with equity markets. We access infrastructure via listed, closed-end investment companies, and our focus has been on less economically sensitive parts of the infrastructure universe.
- Commodity strategies
Accessing carry in commodity markets can be an attractive form of alpha, exploiting the shape of most commodity curves. Long exposure to a constant maturity index and a short exposure to a more traditional commodity index offers an attractive strategy.
In conclusion, by widening our horizon and embracing a wider range of asset classes and investments, we are seeking alternative investments that can help better diversify our portfolios and be additive for return generation.
*Source: Insight and Bloomberg. Data as at 31 December 2020.
- Matthew Merritt is the head of multi-asset strategy group at Insight Investment