Achieving diversification in rising markets

The reason for the correlation collapsing is quantitative easing – the programme of bond buying by central banks. 

Traditionally, bond yields rise (and so prices fall) when economies are recovering and inflation is returning after a recession, with equities rising in response to the good news. 

At times of market stress, equities fall and bond yields fall (so the price is rising) because investors choose the relative safety of government bonds over the uncertainty of equities. 

The correlation has collapsed as a result of central-bank bond buying, as bond prices remain high even when economic conditions are improving. 

This challenges the rationale for the 60 per cent equity/40 per cent bond portfolio, which is based on the idea that one of those asset classes will always be rising, even as the other is falling.   

The challenge this poses is one of diversification; if both bonds and equities are going up at a time of generally rising markets, how can a client have diversification at the portfolio level with downside protection?

For Ben Kumar, senior investment strategist at 7IM, it is important “to find assets which offset each other. The reality is that in an equity-market crash, bonds will probably still do a job, and when markets are rising, equities are rising.

"The key is to always have something in a portfolio which is losing money. But I think the key is to understand that what has happened over the past decade is an aberration, and I think return expectations in future will have to be lower.

"I think it's important that no one ever has zero in bonds or zero in equities.”

Richard Carlyle, investment director at Capital Group, says the 60/40 strategy remains valid, and notes that it performed well in the aftermath of the global financial crisis.

He says: “On rolling five-year periods, the 60/40 strategy works. There is a very small number of periods where it is negative, but if you invest on a five-year basis, then the 60/40 approach works.

"There is no doubt bonds are expensive, but the way to think of the bonds in the portfolio is as insurance, and right now the insurance seems expensive, but, just as with any insurance product, it wouldn’t seem expensive if your house actually burned down.” 

Suzanne Hutchins, multi-asset investor at Newton Investment Management, says one should consider what the most immediate set of risks to a portfolio are, before deviating from the 60/40 approach.

Her view is that the biggest threat to investor returns in the near term is from inflation, so at the present time her mandates have zero invested in bonds, as this would be the asset class she feels is most likely to suffer in the event of persistently higher inflation. 

She says the realisation from policy makers that QE does not work as intended has led to an increased focus on higher growth and higher spending from governments, and that as a result inflation will be higher.

Sunil Krishnan, multi-asset investor at Aviva Investors, says bonds will behave as a diversifier in most economic conditions, and so “will always have a role in portfolios."

He says: “In a scenario where growth disappoints a bit, and so the expectation is that monetary policy will be looser, it is hard to imagine a better diversifier than government bonds, and that scenario happens reasonably frequently.

"The thing is, you don’t need to have something that is completely uncorrelated to equities to be a diversifier, it just needs to not be totally correlated, and government bonds are not totally correlated.”  

Alain Forclaz, deputy chief investment officer for multi-asset at Lombard Odier, says that while bond yields have risen in recent months, they are actually only about where they were at the start of 2020, and were much lower in the initial months of the pandemic, showing that bonds still do act as a diversifier, with prices rising at times of maximum economic stress and then selling off when economic conditions improve. 

But he says that, at the present time, with risks around inflation being much higher than growth, a scenario many call stagflation, government-bond holdings will perform poorly, and that as this is only one of a range of possible outcomes, it is prudent to continue to own bonds as a hedge against the other outcomes.  

In terms of the diversification options in a stagflationary world, Krishnan says absolute return funds can replace some of the bond allocation.

James De Bunsen, who runs the Janus Henderson Diversified Alternatives fund, says that if we do get a profound and long-lasting change in how markets perform, investors should be pretty confident that the assets that have done well over the past decade, across multiple asset classes, will not be the ones that perform well in future.

He says the assets that have performed well over the past decade can be grouped together as “long duration”, and such assets perform best when interest rates are low. If rates are rising from here, this should imply that shorter-duration assets – those that are more cyclical – will perform better in the coming years. 

This implies that assets such as banks and mining companies would do well.