The classic portfolio construction paradigm no longer works – alternatives?

COVID-19 has brought us a historic turning point for financial markets. the core investment strategy that has protected institutional and retail investors for decades – balancing risk by owning high-quality government bonds – is finally done. When the Fed cut short-term interest rates to zero in response to the pandemic, the last straw fell.

The complications that this change brings are enormous. On hand, millions of retailers remained largely helpless, lacking a tried and tested system to diversify the inevitable risk of stock exposure. Similarly, experienced hedge fund managers who use the popular risk-parity strategy face an existential problem: without a good, positive yield on government bonds, they have been thrown into a harsh market environment where it will be very difficult to prosper.

Many investors need to hold stocks because of their ability to bring long-term capital growth above inflation rates. One standard way to blunt the well-known volatility of any risky asset is to balance 60% in equities and 40% in government bonds – the classic portfolio construction paradigm. For the last 20 years, this has worked well because stocks and bonds have been generally negatively correlated: the bond share has risen as stocks have fallen, keeping the overall portfolio at good levels.

In fact, the 60/40 portfolio performed even better. Government bonds were like an insurance policy, acting as a buffer against stock losses, but it was a policy that the government paid. The bond coupon carried a material source of return, on top of the protection you received when diversifying stock risk.

Now this double benefit has become a double danger. Central banks have lowered their interest rates to 0 in the last decade, and thus the yield on coupon payments has disappeared. This remains the task of capital growth only from a source of future profitability. But the place for price growth in general has also decreased.

For this reason, investors are now facing a turning point. For those who hold the classic 60/40 portfolio, things don’t look good. They have lost a source of profitability and their diversification strategy is not working.

Imagine that you want to build a retirement account to save for the future. A traditional 60/40 mix will not bring you any of the diversified returns it once had, and will therefore force you to focus more on stocks.

Over the last three decades, such a portfolio would bring you nearly 10% of the stock per year and just under 6% of the bonds, with a net result of close to 8%. Now, with zero bonds, investors will need a much higher return on stocks to maintain those numbers: 13.3% per year, in fact. This will inevitably encourage higher risk, with the potential for greater losses.

Using such a portfolio without a balance of risk is unfair and irresponsible. Thus, those who save for retirement rely entirely on a sustained rise in stocks – and are seriously exposed to risk.

In the search for new sources of return for balanced portfolios, investors should consider alternatives to bonds, including cash, gold, cryptocurrencies, and volatile strategies – such as stock hedge options – which are unlikely to be available. so well acquainted. There are pros and cons to every choice, but the key is that the diversifying power of bonds is gone, so there is no obvious choice.

This means that we should expect lower stock returns in the future from balanced portfolios, because “free insurance” through bonds is no longer available. Paying for protection has never been an attractive option. But now that investors are dangerously prone to risk, they may at least need to consider the idea.

Source: Financial Times