How to invest when assets are moving in the same direction

The typical approach was to create a portfolio with 60 per cent in equities and 40 per cent in bonds, with the idea that in calm economic times the equities perform well, and in tougher times the allocation to defensive assets, such as government bonds, would perform better.

Amalia Nunez, an investment director at First State noted that an adviser who adopted the above approach over the past forty years would have delivered good outcomes, and made profits from both the bond and equity parts of the portfolio. 

The theory behind this is that when investors are uncertain, they sell off the riskier assets, such as equities and high yield bonds, and switch to assets where the income stream is more predictable, such as a government bond. 

A major challenge to the orthodoxy of the 60/40 portfolio came in the decade after the global financial crisis

When investors are more confident, they shun government bonds, and search for higher returns among riskier assets, because if economic conditions are more benign, those riskier assets can perform as intended. 

What does defensive mean?

Mike Coop, fund manager at Morningstar says: “When people say defensive, I take that to mean assets that won’t lose you money."

He says the most important risk is 'fundamental risk'.

This is the risk that: "what you are invested in doesn’t generate the cash you thought it would.

"We call this fundamental risk, and UK and US government bonds will definitely pay you the money you expect, there is no risk that they won’t be able to pay you, or won’t want to pay you, no matter how bad things are, so there is no fundamental risk, and that's valuable during uncertain economic times.”  

A major challenge to the orthodoxy of the 60/40 portfolio came in the decade after the global financial crisis. 

Policymakers around the world responded to that crisis by introducing a policy called quantitative easing, which involved the central bank buying government bonds, driving the prices up.

The aim was to get government bonds to rise in price, making them relatively less attractive to private sector buyers, and so encourage those to invest in riskier assets that have the capacity to spur economic growth.

Bonds and equities positively correlated

The result of that policy was that bonds and equities both rose at the same time; this is positive for investors but also challenges the central premise of the 60/40 strategy, which is that bonds and equities move in opposite directions.

Nick Watson, a multi-asset investor at Janus Henderson, says the problem for an investor deciding to move away from the 60/40 portfolio over much of the past decade has been that with central bank policy making both asset classes rise in value at the same time, the orthodox approach worked very well, even if it no longer had the protection against market falls.

Charlie Morris, chief investment officer at Atlantic House Investments says: “Bonds have been the real conundrum for investors in recent years, as owning them has meant you made a lot of money in terms of capital gain, but that is not the reason people own bonds.

"The idea is to own bonds for income and equities for capital gain, but in recent years it has been the other way around.” 

But Mr Watson notes that during the market carnage in March, government bonds, despite being at very low levels, performed as the original 60/40 theory implies they should, by rising in value.

The defensive qualities of gilts (UK government bonds) were demonstrated during the sell-off in March when it was the only sector in the Investment Association universe to go up, gaining 1.6 per cent.

Ben Yearsley, investment director at Fairview says “Gilts acted as a diversifier, by rising when other assets were falling in price.” 

He says for this reason he “would always have some government bonds”, but adds that investors will likely emerge from the present crisis into a market where equities have fallen sharply in value and so are cheaper than they were, while government bonds have become more expensive than they were.

He said this may mean multi-asset portfolios switch to an 80/20 mix, with equities being the 80, to reflect the gap in valuations.

Mark Jackson, investment specialist at JP Morgan says with economic uncertainty rife, he expects that bonds will continue to outperform against equities in such a climate, even with valuations where they are, so he prefers to own bonds and also to hold cash.

Sunil Krishnan, head of multi-asset funds at Aviva Investors says the evidence of recent years shows that however low bonds yields have gone, “they can always go lower. "

This is especially true as interest rates have been cut, and it is hard to see rates rising anytime soon. Given the uncertainties that are out there, policy makers will not be rushing to put rates up. 

Mr Coop says that while government bonds pose no “fundamental risk”, another risk that can cause an investor to lose money is “valuation risk”, which comes from paying too much for an asset.

He says that with bond prices already high, the risk is that economic events in the coming months and years cause inflation to rise, this reduces the spending power of the income generated from the bond and so make the price fall. 

Mr Coop said: “If an asset is already cheap, then there is relatively little risk on the valuation side, but with yields where they are, it is difficult to say that government bonds are cheap right now.”