Written by LGT Crestone Senior Portfolio Manager Stan Shamu
Equities and bonds have traditionally been the main building blocks of multi-asset portfolios. The key reason for this pairing is that the asset classes have historically had uncorrelated return profiles. Generally, in periods when risk sells off, equities will weaken and bonds will perform better. This provides the investor with a degree of protection in challenged environments. Reflecting this, the so-called ‘balanced portfolio’ was premised on a combination of a 60% allocation to equities and a 40% allocation to bonds, with an objective of achieving attractive risk-adjusted returns over the long term.
In this Observations piece, we explore the traditional 60/40 approach for building multi-asset portfolios. We also explain why investors may benefit from adopting a more flexible approach that incorporates a broader range of diversifiers and is not overly dependent on a particular outcome.
The reality is that the relationship between equities and bonds is not that simple and their correlation has not always been negative.
The reality is that the relationship between equities and bonds is not that simple and their correlation has not always been negative. Over time, correlations have been volatile and, at times, positive—as has been the case more recently.
As can be seen in the chart below, which shows the long-term correlation between global equities and bonds, correlations have generally been negative. Between 1995 and 2023, this relationship has been negative nearly 80% of time—however, correlations peaked at the end of 2022. Since then, they have remained positive (and volatile).
Macro-economic factors tend to drive equity/bond correlations and historically, inflation has been highly correlated to this relationship. According to Franklin Templeton, “during periods of moderate inflation, the correlation has historically been flat or negative and subsequently positive in high inflation environments”.
Referencing the earlier chart, while equity/bond correlations were positive through the 1990s, they turned negative from the early 2000s through to 2022. Post-COVID, the spike in inflation has been the primary driver of the positive equity/bond correlation. Central banks tackled rising inflation by embarking on very aggressive rate-hiking cycles. This occurred at a time when both equity and bond prices were elevated, with the latter having experienced zero to negative yields in most parts of the developed world. The spike in short-term rates resulted in bonds selling off and also had a negative impact on equities, given high discount rates.
Post-COVID, the spike in inflation has been the primary driver of the positive equity/bond correlation.
Equity/bond correlations do not have to be negative for a 60/40 portfolio to work—but they do need to be low or heading lower. However, when correlations are in a positive upwards trend, this lowers the relative effectiveness of core fixed income as a diversifier within multi-asset portfolios.
The following chart shows the historical performance of a typical 60/40 portfolio and the contribution to performance from equities and bonds. It shows how bonds can provide protection in periods of equity market drawdowns. One example is in 2008 when equities fell nearly 40% but bonds rallied 15%. However, we can also observe that in 1994 and 2022, when equities and bonds were highly correlated, bonds did not provide protection when equities fell.
Given the ebbs and flows of the equity/bond relationship, we believe it is prudent to adopt a dynamic approach to portfolio construction.
Given the ebbs and flows of the equity/bond relationship, we believe it is prudent to adopt a dynamic approach to portfolio construction to accommodate for short-term shifts. This would require reducing exposure to fixed income and/or equities during periods of high positive correlation and seeking other diversifiers. The following highlights some of the ways we have been looking to diversify exposure in our portfolios, as well as the core elements of our portfolio strategy.
With volatility likely to persist in the short term, we believe that investors would benefit from being more tactical and detailed when allocating to their fixed income investments, particularly when there are ’regime’ shifts. While portfolios should continue to have adequate exposure to government bonds as a core defensive allocation, ignoring other parts of the fixed income asset class is unlikely to yield a desirable long-term outcome. Fixed income incorporates a broad spectrum of assets that can improve portfolio efficiency, and we believe investors may benefit from considering or decomposing sub-asset class betas, such as interest rate duration, credit duration, credit quality, and capital structures. This should provide a much better look-through and flexibility for portfolios. We also believe that having some floating rate debt exposure can provide a better investment outcome in a rising rate environment. As such, a ‘barbell’ approach with fixed-rate exposure may be beneficial.
Defensive alternatives tend to have more moderate return targets and bond-like volatility profiles.
Alternatives (which include unlisted equity and debt, real assets and hedge funds) add a variety of features to an investment portfolio. In particular, exposure to this asset class can improve a portfolio’s return potential and defensive qualities via improved diversification and due to its low correlation to traditional asset classes.
Defensive alternatives tend to have more moderate return targets and bond-like volatility profiles. At LGT Crestone, we have embraced defensive alternatives to complement the role played by traditional fixed income. As an example, we see opportunities to build long-term core exposures to global private debt at attractive yields. Additionally, a higher level of dispersion in credit spreads presents opportunities for credit-orientated hedge funds. Defensive characteristics of some real assets with consistent income profiles, such as infrastructure, also present diversification opportunities.
A higher level of dispersion in credit spreads presents opportunities for credit-orientated hedge funds.
At LGT Crestone, we have always advocated that investors should adopt an active approach to portfolio management to improve downside protection and generate returns in excess of a benchmark over a market cycle. Active management tends to outperform passive approaches in high-dispersion markets where security correlation is low. And while this approach has proven challenging in recent years, we believe it will perform better in an environment where idiosyncratic risk and the cost of information is high. The reality is that businesses will need to navigate a number of challenges in coming years, which may negatively impact their operating models and balance sheets. Active management is a prudent approach that helps an investor avoid these potential pitfalls, and should be a key part of an investor’s portfolio strategy going forward.
Rebalancing takes the guess work out of investing and ensures investors remain on course with their long-term investment strategy and objectives.
With equities having recently traded to record highs, it is prudent to maintain a well-diversified portfolio that is not overly dependent on a particular outcome, and that might leave investors exposed to unpredictable risks. Diversification will continue to play a key role in enhancing the robustness of portfolios. From our perspective, being prudent with asset allocation and having ample exposure to high quality funds across sub-asset classes and styles are the key components of diversification. And well diversified portfolios should yield better risk-adjusted returns over the long run. At LGT Crestone, we have been seeking to diversify our equities exposure by investing in small and mid-caps, Japan and equal-weighted S&P 500 as the rally broadens out.
With regards to rebalancing, this takes the guess work out of investing and ensures investors remain on course with their long-term investment strategy and objectives. Additionally, failure to rebalance can threaten the diversification benefits of a portfolio. It is best practice to set limits or ranges around how far the actual asset allocation and underlying instrument weights can drift from their target asset allocations (i.e., tolerance levels).
While quality is always an important part of any investment strategy, it is even more critical when there are correlation challenges. This aspect of portfolio strategy ties in with rebalancing, diversification, and active management. When market conditions become stressed, the divergence between quality stocks and the broader index has historically increased, particularly as the cost of capital increases. This is shown in the following two charts—firstly post-GFC and post-COVID. This phenomenon is also evident in fixed income markets, where instruments from debt-laden sovereigns and companies are out of favour. In this environment, it is imperative to differentiate between assets that have solid fundamentals and those that have a real probability of capital loss.
At LGT Crestone, we believe that adopting a risk factor framework opens up multiple future development pathways. This allows additional modularity and granularity in our portfolio construction capabilities as opposed to a blanket approach of the traditional 60-40. This is also particularly beneficial in an environment where alternative investments are increasingly prominent in portfolios. Central banks have done the heavy lifting in countering accelerating inflation and data suggests inflation is on the right path. If inflation is under control, we could finally see the correlation between equities and bonds begin to fall. This could lead to the defensive 40% of the traditional 60/40 balanced portfolio once again providing the protection and desired characteristics that investors have previously grown accustomed to. However, if central banks are not able to control inflation, the 60/40 portfolio will continue to be challenged. Embracing a risk factor framework enables us to remain nimble through the process.
At LGT Crestone, we aim to build portfolios that are not dependent on a particular outcome to deliver on long-term objectives. We believe that to deliver on a portfolio’s long-term objectives, investors should ensure portfolios are suitably diversified and nimble. They should also be selective with instrument quality, actively manage their portfolios, be opportunistic, and rebalance their portfolios.
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