With interest rates falling to historical lows the reality of a new financial landscape is confronting investors. It is one where the typical relationships between assets has come into question. In addition, basic ideas around diversification and portfolio construction no longer seem to match with the available investment opportunities.
- The fall of interest rates to historical lows means the old approach to diversification is no longer tenable
Most important is the fundamental question of diversification. Over the past 40 years, a simple position in a fixed income asset, such as long-dated, highly-rated US Treasuries was considered the exemplar of safety. They provided excellent diversification while also providing strong positive returns. Investors must now ponder what will replace the role of this allocation in portfolios?
There are two answers. The first demands a quantitative analysis of a range of asset classes, attempting to find proper diversifiers. However, such analysis will probably be historically-focused in nature. This means it will be based on an environment of steadily and significantly falling interest rates that is unlikely to pertain over the next few years.
Secondly, an investor could go back to first principles, trying to understand the key characteristics that investors desire from diversifying assets. Which of those assets is likely to continue to behave as it has done previously? This approach is likely to be more effective, as it focuses on the underlying challenges. That is rather than simply running regressions and optimisations “to find the right answer”.
The second approach begins with the most fundamental questions of all: what is diversification and what have investors gained from it?
Diversification is used by investors to mean two different things — preservation of capital (assets that do not fall in value during market drawdowns), but also inverse performance (assets which increase in value during tough market times).
Over the past 40 years, safe fixed income has easily fulfilled both roles. This could be seen as a period of ‘painless diversification’ (an environment where safe fixed income delivered high returns, while providing strong diversification benefits). The challenge investors face today is that these golden years have probably come to an end.
The claim that painless diversification is supported by evidence. Interest rates are more able to rise than to fall from this point. In the past, fixed income provided a ballast to the overall portfolio as rates tended to drop during times of real economic and or market turmoil. Historically, a 2-3% drop in interest rates during economic hardship was normal, and this resulted in big gains for fixed income investments. A move of that size today would require deeply negative interest rates and is, therefore, less likely to occur. It seems easier to imagine scenarios which involve mild or material upward moves in interest rates in the current environment.
So what should investors do? There are several answers. Any solution requires two key realisations:
• Sometimes desired goals are impossible to achieve. Focusing on trying to create an impossible solution makes it harder to deliver responses that appear less attractive, but are achievable. The environment of the past 40 years is unlikely to repeat itself over the following 40. In other words, the behaviour of diversifying assets over that 40 years was uniquely beneficial.
• Complexity does not, in itself, drive better outcomes. In the same way that some goals are impossible, it is also necessary to recognise that adding complexity to solutions does not in itself change the underlying dynamics of the economy or the markets. Current market structure and pricing suggests that both risk-free rates and normal market betas are likely to perform worse than their historical averages over the next decade. Products that fail to recognise that reality and that claim to generate significantly different outcomes through complex structuring need to be looked at with appropriate scepticism.
It is now possible to move on to understand the different ways to approach the contemporary challenges of diversification. The search for assets which might provide the painless diversification of high returns along with great diversification benefits can be concluded as those assets may no longer exist. Instead it is possible to identify the different flavours of diversification as well as the specific asset classes which might provide each flavour.
• Principal protection approaches: This requires that the exposure that is being bought suffers little to no price shock when risk markets are hit. It also means that the asset remains liquid during that environment. Cash and high-quality fixed income will probably continue to fulfil this role.
• Inverse performance approaches: This requires an asset that performs well when risk assets perform poorly. The traditional approach of buying long duration assets may still fulfil this role, though likely in a more limited way than previously. Gold may perform well during market turmoil, but this must be balanced against the fact that as an asset it can experience large swings in value for idiosyncratic reasons.
• Diversification as difference: This approach is different. For certain asset classes, prices may zig when the broader market is zagging (correlation close to zero). These assets may provide higher income and possibly some desirable duration properties. Those with little or no correlation to broader markets may add diversification value by changing the shape of future outcome distributions for the portfolio. This can be done in a way which is likely to mitigate the effects of downside events. Certain private real estate and infrastructure may provide lower-correlation exposure with duration properties. Investors who seek truly uncorrelated strategies might pursue exposures such as catastrophe bonds, litigation finance strategies, or unique hedge fund trading styles.
Over the past 40 years, investors have benefited from painless diversification by simply holding traditional fixed income. This was possible as yields were high, interest rates were falling, and bonds offered strong diversification during sell-offs.
Under such circumstances it is important for investors to recognise two themes: First, no asset class today is likely to offer both preservation of capital and inverse performance. Investors may be well-served by focusing on specific diversification characteristics and then appropriately allocating to asset classes and strategies that may provide those benefits.
Second, it should be accepted that adding complexity to solutions does not, in itself, change the situation. Complex strategies which claim to defy these market dynamics should be looked upon cynically.
Ian Toner is CIO and Thomas Garrett director, strategic research, at Verus. This article is based on a January 2021 white paper