The time has come to break investment tradition

Search supported by
The time has come to break investment tradition
Photo by Karolina Grabowska from Pexels

The 60/40 portfolio split between equities and bonds has been a well-known and trusted strategy for decades, created to provide investors with a balanced, stress-free portfolio that offers the security of bonds alongside the potential for growth from riskier equities.

However, times have changed, particularly since the pandemic and lockdowns that started in March 2020. And in a period of consistently low bond yields, the safety and comfort that investing in bonds once provided can no longer be relied on.

So, it’s vital that investors re-examine and re-imagine how that typical 40% fixed income allocation is formed. For those who are willing to break from tradition and look beyond the typical make-up of government and investment-grade corporate bonds, we believe there are pockets of opportunity to be found. 

Most of the time, an investor’s bond portion is implemented by buying huge passive products, predominantly focused on developed market issuers. These products are optimised for simplicity — they lend to a wide range of borrowers without reference to their credit worthiness or the level of interest they are paying. 

Currently, a staggering 30% of developed government bond issuance offers negative yields, requiring investors to pay for the privilege of lending to them. At the same time, large, stable companies have never offered less compensation for the extra risk taken in lending to them instead — if we’re following in the tradition of a typical fixed income portfolio breakdown, this what investors would end up buying. 

In addition to low yields, fixed income markets have also become far more highly correlated to equity markets due to central bank intervention. This means investors can no longer rely on traditional bonds for their diversification needs.

All of this should be leading you to ask, why not break with tradition and think differently? 

Pockets of opportunity 

We’re currently positioned to take advantage of the US residential mortgage space. US consumers have never had so much cash in their pockets or a house that is worth so much. Combine this with mortgage rates being at an all-time low and you create the perfect backdrop for re-mortgage activity. People either want to stay where they are and pay less, or move onwards and upwards. 

To take advantage of this trend we’re invested in the Angel Oaks Multi-Strategy Income Fund, which directly benefits every time someone repays their mortgage. This is currently providing an extra 2% yield over what you receive when lending to a corporate. 

Investors should also be prepared to look outside of the main passive indices. One area of opportunity in this regard is lending to European banks. Regulators insist that banks issue special ‘additional tier one’ bonds, to protect the financial system. Because these bonds are a bit different, they aren’t eligible for the traditional indices, and because they are a little bit harder to analyse, many investors have shied away from them. 

However, it is worth making that extra effort with what’s on offer — well-capitalised, low-risk national champion banks paying 2% more on this debt than what their traditional bonds are paying. 

We’re also looking outside of developed markets and venturing east. For investors willing to jump that geographical hurdle, you can find that Asian companies of equivalent credit quality to their US counterparts and issued in the same currency offer 4% more per year on their debt — and in a faster growing economy. We’re currently accessing this opportunity with UBS through Asian high-yield corporate bonds. 

Achieving better balance 

A genuinely diversified multi-asset portfolio has a much clearer role in today’s prevailing environment of low bond yields, negative debt piles and returning inflation.

To improve diversification, we believe investors should look to break with tradition even further and incorporate a wider range of assets to achieve the balance across portfolios that bonds used to provide.  

In line with this, we are strategically using more liquid alternatives, higher weights towards emerging markets and more diversified credit exposures, for example, to provide a better overall risk/reward profile.

For a balanced portfolio, we would currently expect to see an allocation of circa 15% in alternatives, a split which will likely only increase over time, given the trajectory of equity markets and traditional bond yields. 

It’s important to remember, however, that breaking from tradition does not mean just buying assets exposed to more risk. To stay true to risk mandates, investors cannot simply pile into equities instead of cash, or just load up on low-quality credit to beat inflation.

The opportunities noted above offer examples of pockets of value we can look to take advantage of. However, in the same way we don’t believe that moving up the risk ladder in regards to corporate bonds offers much by way of yield to counter inflation, we also don’t think that alternatives such as private equity will suit many portfolios, given this is simply leveraged equity.  

Instead, for investors seeking balanced portfolios, we look at options such as absolute return vehicles, which can generate 3–4% per year. One example is a mergers and acquisitions-focused strategy that has been benefitting from a post-Covid resurgence in corporate activity — we do this via the BlackRock Event Driven Fund. 

In a world of rising inflation, trend strategies that can capitalise on rising commodity prices and increasing yields are a useful exposure for portfolios to access. One fund we like here is the AQR Managed Futures Strategy. 

The reality is that we are living in a world where it is much harder to invest. But for those willing to look for it and to break from the conventional 60/40 split, there are opportunities both within the world of fixed income and beyond. 

It turns out some traditions are there to be broken.  

The information and/or any reference to specific instruments contained in this document does not constitute an investment recommendation or tax advice. Capital at risk. The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.

Tony Lawrence, senior investment manager, 7IM