The dangerous science of buckets

Why absolute return fixed income challenges traditional asset allocation thinking.

2 minute read

In his book, Behave, author Robert Sapolsky urges his readers to rid themselves of “categorical thinking”. He uses the visual spectrum to make his point. The distinction between colours is arbitrarily drawn, and each language slices and dices the boundaries differently when they assign words to colours.

Why is this important? As Sapolsky explains, “Show someone two roughly similar colours. If the colour boundary in that person's language happens to fall between the two colours, the person will overestimate the difference between the two. If the colours fall in the same category, the opposite happens.”

So once a categorical boundary exists we start to place far too much importance on something that is, in essence, arbitrary, and you lose sight of the bigger picture. The lessons here for investing are huge.

Characteristics vs labels

When you think about the asset class buckets we have created in the investment industry, they essentially represent the same bias. By drawing lines in the sand between asset classes, and throwing them into categories, we are in danger of losing sight of the broader picture: that the characteristics of assets are what matter to a portfolio, not their labelling.

BY way of example, private and infrastructure debt are fixed income investments that provide stable cashflows, it is the fact they are priced infrequently that make them an ‘alternative’ asset. These assets have characteristics that many investors will desire, and which might be in short supply if we adhere too closely to traditional definitions.

Absolute return fixed income funds create similar challenges in terms of categorisation, with many investors placing them in the alternatives bucket. There are, however, some credible reasons for challenging this view.

Firstly, given the challenging backdrop for bonds, investors could use a helping hand with their fixed income portion of their portfolio. Or put another way, investors need to think differently.  Whether we have finally reached the end of the thirty-year bond bull market is still up for intellectual debate, but one thing that we can be sure of is that returns on traditional fixed income are unlikely to be as strong as they have been in the past. The characteristics investors have historically sought in bond markets – capital preservation, steady and predictable returns, and diversification from riskier assets – will be challenged in the years ahead.

Secondly, regardless of the future environment, the need to create well-diversified portfolios (and by definition the component segments of portfolios) is essential. The historical benefits of investing in fixed income as a diversifying, defensive strategy are fading. The negative correlation between bonds and stocks highlights the historical reliability of the diversification benefits. However, more recently we can see that those assets have become positively correlated. Diversification is becoming ever-harder to find.

Lastly, if investors recognise the importance of having assets within their portfolio that have low or negative correlations to large chunks of the rest of their portfolio, then it makes sense to find some space in their portfolio for assets that offer this, regardless of which bucket they assigned it to.

Conclusion

The overriding point here is that our rigidity of thought can often result in us losing sight of the bigger picture. How we define borders and boundaries limits our overall portfolio dynamics and, ultimately, our risk/return profile. If you accept that fixed income markets have shifted irrevocably to an environment in which investors must expect considerably lower returns, then it makes sense to radically alter your thinking to accommodate for this. Removing the ‘alternative’ label from absolute return bond funds might not be a bad place to start.

Important information

Past performance is not a guide to future performance. The value of an investment and any income from it may go down as well as up. You may not get back the original amount invested.

Except where stated otherwise, the source of all information is Aviva Investors as at 21st March 2019. Any opinions expressed are those of Aviva Investors and they should not be relied upon as indicating any guarantee of return from an investment in our funds.

Nothing in this article is personalised advice or a recommendation. If you need a personalised recommendation based on your personal circumstances, you should seek financial advice.

11514 03/2019