Hawkish central bankers, inflation and Russia’s invasion of Ukraine has demonstrated that a 60/40 portfolio may no longer be the portfolio of choice when effectively managing portfolio risk.
We may be seeing a regime shift in the correlation between stocks and bonds, where bonds offer little hedging benefits to equity downside risk.
Published in the Journal of Fixed Income, Stock-Bond Correlations by Antti Ilmanen (2003) found that inflation shocks are likely to cause equity and bond correlation to increase, because of the impact on short-term interest rates. Incidentally, growth and volatility shocks are likely to increase the divergence of expected returns.
This has led a lot of market participants to consider increasing their allocations to alternatives, such as property, private equity and hedge funds.
Prices in the private markets, including commercial and residential property markets, have however been driven by the same factors as the public markets, and likely provide little diversification benefits as these factors reverse.
Hedge funds have also continued to significantly underperform on a risk-adjusted basis.
Investing directly in private equity, hedge funds and commercial property can also take away investors’ liquidity as illiquid assets may mean investors are unable to effectively withdraw their investment. This liquidity is likely to grow more important as the cost-of-living crisis bites and household savings continue to fall.
An alternative way of gaining exposure to the private markets could be through fund-of-funds.
However, this would create multiple layers of fees for the end client, making the process both complicated and expensive.
Fundamentally, as long as the underlying assets are illiquid, investors can face severe issues when redemptions rise above expectations.
This notably was seen with property funds during the pandemic when M&G, Threadneedle and St James’s Place were forced to suspend their property funds.
Commodities, beyond their return potential, can be used as a hedge against inflation within the portfolio.
Typically, when inflation increases, commodity prices also increase as many commodities are used in the production process for the end products that are experiencing the price increases.
For example, if food prices are increasing, the inputs for that product may also increase.
Commodities also provide effective correlation as they are largely independent to stocks and bonds, and positively correlated to inflation.
The long-term benefits of adding commodities to a stock/bond portfolio is well supported by academic literature.
Despite this, investors benefitting from the stellar performance of the equity markets in the past 15 years may have led investors to neglect the importance of diversification.
