Janus Henderson Investors  

Fund Selector: Art of balancing a portfolio

Fund Selector: Art of balancing a portfolio

Does anyone need more than two asset classes in their portfolio? After all, for a period of time that stretches back beyond the careers or memories of most investment professionals, a balanced portfolio of stocks and government bonds has provided an almost unbeatable risk-adjusted return.

This kind of portfolio also has the added benefit of being entirely liquid, so for anyone disposed to dynamically flex their bond/equity allocations, they can do so easily and at a very low cost. Alternatives, on the other hand, can be expensive, much less liquid, and have a tendency to be highly correlated to equities, just when you don’t want them to be.

Government bonds have benefited from both a multi-decade decline in interest rates that began in 1981 and their status as a liquid, safe-haven asset class – a home for capital that periodically flees volatile equity markets. While it is hard to dispute some of the safe-haven characteristics of these bonds, the ground seems much shakier when it comes to fundamentals and technicals. In other words, yields have never been lower, government debt levels never higher, and benchmark duration never longer, while central banks are stepping back and inflation is ticking up.

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When faced with the decision of which asset class genuinely offers some safety in a risk-off market, I’d go for zero yield and no duration; that’s to say, cash rather than zero yield and eight to 10 years of interest rate risk.

I’d also have some gold. But while the precious metal has some great hedging characteristics, I ascribe to it no expected return. Crucially, all the other alternatives in my portfolios are expected to generate attractive, risk-adjusted returns in a variety of market scenarios, as well as offering diversification. This might sound a bit obvious, but at these levels government bonds offer no returns, plenty of risk and a perhaps misguided assumption of ongoing negative correlation benefits.

Alternatives should be viewed differently and each asset class or strategy gauged on its own merits. Some alternatives – for example, private equity, directional hedge funds, or specialist credit funds – should be expected to behave in a very similar manner to equities and therefore treated from a risk standpoint in almost the same way. 

Then there are alternatives that have the potential to look very different to stockmarkets, but can at times of stress also be almost indistinguishable – think commodities and property. And finally there are strategies and asset classes that should have a negligible correlation throughout the cycle, such as market-neutral and merger-arbitrage funds, social infrastructure and certain alternative risk premia. 

It is these latter strategies that are, in statistical parlance, orthogonal in nature and add true diversification to a portfolio. The others can be lowly correlated at times, but are fairly reliably positively correlated to equities when you would rather they weren’t. 

My portfolios are full of alternatives (and cash) at present, not because of some vague hope that they will bail me out when equities correct, but because I see little value in mainstream stocks and bonds right now. Instead, I see genuine opportunities in some less mainstream assets and in strategies run by managers with excellent track records in generating returns that are not entirely dependent on markets trending ever upwards.