Equity alternatives to bonds
A market neutral investment in equities can complement a holding in ‘less risky’ but overvalued bonds
In a macroeconomically driven environment, investors can struggle to find ways to diversify their holdings. Swings in the market are relatively highly influenced by a few big overall trends. Investments which are completely desensitised to swings in the wider markets –so-called market neutral investments – could provide a solution.
The mantra of the current environment is ‘risk on, risk off’. Every day, or so it feels, macroeconomic events are swinging investors from one extreme to the other, inducing them to put more overall risk into their portfolio or take it out. Even the most powerful political and financial leaders appear unable to influence, let alone steer, this process. One day highly economically sensitive stocks race ahead. The next day short-term treasuries are the only safe haven.
Like a plague or a flood, these swings have scant regard for the characteristics of traditional asset classes, never mind the virtues of specific stocks. The trend toward closer correlations – the tendency for different types of assets to move in the same direction at the same time – has been evident for many years. But the macroeconomically driven markets seen since 2008 appear to have accelerated the process.
The MSCI equity index series, for instance, defines six regional equity classes – the US, Japan, Europe excluding UK, the UK, Asia Pacific and emerging markets. If you pair these regions off, 16 of a possible 21 combinations exhibit patterns of returns that were more than 80 per cent identical in the five years between 2007 and 2012. None were less than 70 per cent correlated and all of the five that were less than 80 per cent related to Japan. Nine of the pairings were more than 90 per cent correlated. The correlation between ‘high risk’ emerging markets and ‘defensive’ UK equities was 82 per cent. Between emerging markets and the US it was 86 per cent. Interestingly, the correlation between emerging markets and the world index was 91 per cent – relatively high.
These numbers tell us what investors already know – there is nowhere to hide.
This has led many investors to resort to ‘core government’ bonds as defensive assets – especially gilts, US treasuries and German bunds. But these areas have pitfalls of their own.
The first is that their ‘safe haven’ status has made them extremely expensive. They are vulnerable both to inflation – currently 2.5-3 per cent, significantly higher than the 1.7 per cent yield on a 10-year gilt – and to a sudden correction. The second is that they have a negative correlation to equities. It is not an exact counter-balance, but an ‘opposite and nearly equal’ relationship, with global government bonds over the past five years rising or falling by 30-50 per cent relative to equities.
A market neutral equity portfolio seems to offer a cheaper, longer-term and more effective solution. By far the greatest risk in owning equities is the volatility of their prices. By taking out exposure to the market, or the beta, price volatility is quite literally neutralised, leaving investors exposed to pure returns. These can have minimal correlation to the market as a whole, and because there are always stocks moving in the opposite direction to the trend, investments can be focused on positive absolute returns even in the most ‘risk off’ conditions.