All My Eggs In One Basket

On June 16th the yield on 10-Year US Treasury Notes was higher at ~1.6% after the Federal Reserve signposted a rise in interest rates next year with two increases pencilled in by 2023. The announcement coincided with an upwards revision to the central bank’s inflation and economic growth forecasts. Given the developments, we consider it pertinent to reassess the possible effects of higher yields on the global stock market.

Following the assumptions of Henry Markowitz’s Modern Portfolio Theory, market participants can reduce unsystematic or specific risks by combining a number of risky assets, and without compromising on investment returns, provided that these returns are not positively correlated. While the correlation between stock and bond prices is a crucial element in the process of portfolio optimisation, the traditional model assumes a stagnant relationship, however historical data over longer periods of time may suggest otherwise (see Figure 1) (continued on pages 2 & 3).

To illustrate the benefits of diversification, we consider a portfolio that is partially invested in Australian Equities, International Equities, Australian Property, International Property, Australian Bonds, International Bonds and Gold; with the relevant benchmark indices used as a proxy. Following the assumption that investors are risk averse (and therefore seek to minimise risk for a defined rate of return), our methodology for testing minimum variance portfolios includes calculating annual sample statistics for the mean return, standard deviation, correlation and covariance on each underlying asset class using monthly data points over the 10-year period ending 31 May 2021.

By changing the mix of portfolio weights invested in each asset class, we can map the Minimum-Variance Frontier, as depicted by the black curved line in Figure 7, which represents the continuum of risky asset portfolios that a rational, risk-averse investor would choose. While we have considered risky assets in which the returns are uncertain, investors will also have access to a risk-free asset. Using the yield from the 10-Year Australian Government Bond as an appropriate estimate for the risk-free rate of return, we can create a composite portfolio that consists of a risk-free asset and a portfolio of risky assets, as shown by the straight Capital Allocation Line in Figure 7. This allows us to narrow the selection of risky portfolios to a single Optimal Risky Portfolio, which occurs at the point of tangency between the Capital Allocation Line and the Efficient Frontier of risky asset portfolios, such that the gradient of risk-adjusted returns are maximised. To demonstrate this, Figure 6 displays the Sharpe Ratio for various asset classes and our diversified Optimal Risky Portfolio consisting of International Equities, Australian Bonds and Gold (for information purposes only).

The extent to which expected portfolio returns can be maximised for a given level of risk is dependent on the correlation between different investments. The standard deviation of a portfolio’s expected return is a function of the weights, volatility and correlation between underlying constituents. Asset classes are correlated to one another if they produce similar returns in similar market environments. Therefore, the lower the correlation between investments, the greater their collective potential is to reduce the overall risk profile of a portfolio.

While effective, the standard approach to asset allocation is inherently time-biased due to the sampling of historical returns. Economic conditions, for example, may be a decisive factor in the determination of rolling stock-bond correlations. When deflationary fears rise, bond yields contract, raising bond prices, personal savings increase and reduced prices impede on earnings, driving stocks lower. When these deflationary fears subside, yields rise, lowering bond prices and stocks rally. The resulting stock-bond correlation is negative. However, when inflationary fears rise, bond yields expand, lowering bond prices and higher labour, material and borrowing costs impede on earnings, driving stocks lower. When these inflationary fears subside, yields compress, raising bond prices and stocks rally. The resulting stock-bond correlation is positive.

Assuming that this correlation is positive, Hedge Funds present a major attraction due to the sophisticated investment approach employed, with often involves the application of derivatives and short-selling, resulting in low correlation to traditional asset classes. Montaka listed Australia's first Long-Short ETMF in June 2020, with Monash Investors recently converting their Long/Short Australian Equities LIC to an ETMF in June 2021.

In the following report, we also provide sector summary ETFs under our coverage. You can access the report in full below.