As the era of extraordinary monetary stimulus draws to a close we believe that it is time to take a new approach to multi-asset investing.
In 1952, Harry Markowitz, the Nobel Prize winning economist, developed Modern Portfolio Theory. Like nutritionists who recommend eating a balanced diet, rather than guzzling solely on chips, he discovered that mixing a selection of assets with different risk and return characteristics can create the optimal portfolio. And for over 50 years his theory has been widely accepted as the staple diet for investment professionals managing portfolios.
At the heart of Markowitz’s theory is diversification; the idea that holding a variety of investments smooths out some of the bumps in performance and helps preserve capital during periods of market stress. Reflecting the more limited investment options available at the time, this concept led to the popularity of simple 60:40 equity and bond portfolios, which have tended to deliver decent returns for investors. This was particularly true during the past decade when returns were supercharged by ultra-loose central bank monetary policy. However, bull markets cannot last forever.
Is a diet of just equity and bonds healthy?
Past performance is not a guide to future performance.
In an environment where inflation is creeping up and monetary policy is becoming more restrictive equities may continue to perform well, but bonds will probably struggle. With the yields on global bond indices having declined to historical lows, whilst interest-rate risk has increased, the defensive qualities of bonds have become less attractive. In fact, the defensive characteristics of bonds have already become less reliable as seen in the ‘Taper Tantrum’ of 2013, the ‘Bund Shock’ of 2015 and the sell-off earlier this year when falling bond prices actually precipitated a sell-off in equities.
Broadening the menu
These episodes explain why taking a different approach to managing multi-asset portfolios can be helpful.
Firstly, bond diversification should be enhanced. Rather than treating bonds as one homogenous low-risk asset class we are careful to differentiate between high-risk and low-risk bonds. High-risk bonds are treated like equities, whereas low-risk bonds are treated as a defensive asset. Furthermore, we look to diversify geographically and include non-mainstream fixed income assets, such as emerging market debt and Australian government bonds.
Secondly, additional asset classes are necessary. By adding lower correlated assets, such as absolute-return strategies, broad diversification gains can be made.
Thirdly, active management of asset allocation. It makes sense to have the flexibility to increase or decrease risk as well as make specific sector and style calls. Moreover, when reducing risk, we do not have to add bonds. We can use other assets such as cash or property.
Diets are notoriously faddy but one golden rule seems to stand the test of time: balance. Portfolio management is no different. By diversifying return streams we are in effect adding a few more vitamins and nutrients to the portfolio. This by no means implies that we have permanently cracked it. We must constantly stay alive to new tastes and techniques. As the late famous chef Anthony Bourdain once said "without new ideas success can become stale".