Vantage Point: Volatility  

Building a defensive portfolio at a time of heightened volatility

  • To understand the correlation between bonds and equities.
  • To discover how some of the alternatives perform at times of heightened volatility.
  • To understand how bonds are impacted by economic volatility.
Building a defensive portfolio at a time of heightened volatility
Credit: Pexels

Managing portfolio risk used to be a simpler task: first set your allocation to equities and then diversify risk through an allocation to bonds (corporate and government). This is what has become commonly known as the 60:40 portfolio. 

This method has worked brilliantly as the ‘low-risk’ bond diversifier in the portfolio has been in a 30-year bull trend so you have made positive returns from both parts of your portfolio. Bonds have also done a decent job in reducing portfolio drawdowns during significant market crashes such as the global financial crisis or the recent Covid-19 crash.  

The idea that an allocation to bonds within a portfolio can help reduce your risk relies on making assumptions about correlation – or in other words, how the prices of both asset classes will interact; if bond prices go up when equity prices go down, you reduce risk, simple enough. 

What happens when bond prices go down at the same time as equity prices, like we saw in the first quarter of the year? Well, you lose in both parts of your portfolio and suddenly that 60:40 portfolio allocation does not look so clever.

Many commentators have wrongly called the end of the bond bull market. Whether August 2020 truly marks the top of the market for government bond valuations or not remains to be seen, but what we can say with certainty is that bonds have done a very poor job in reducing portfolio drawdown so far this year. 

Persistent, high inflation has forced the hand of central banks and they have started to reverse the era of ultra-loose monetary policy through raising interest rates and signalling the end of quantitative easing. 

It seems reasonable that as the asset class that has directly benefited the most from loose monetary policy, bonds stand to suffer as monetary policy is tightened. 

As portfolio managers there is clearly a lot to contend with in the current environment; the Russian invasion of Ukraine has only exacerbated inflationary pressures. 

Our approach to managing risk is very different to the traditional equity/bond allocation in a 60:40 portfolio: we take a bottom-up approach rather than top-down, focusing on building a portfolio of diversified strategies from the investment company and derivatives universes. 

Both these universes are broad, which affords a high degree of flexibility to the fund mandate. With our investment priorities, our primary focus has to be on managing risk.  

The starting point is to seek out investments that we believe will have a low sensitivity to the broader economy, which tends to lead us to alternative asset classes and to using derivatives to structure investments with low correlation to the more traditional parts of the market, such as equities and bonds.  

This helps us remain defensive when financial markets experience periods of high volatility usually associated with drawdowns.