The days of uncorrelated bond and equity returns could be behind us

Investors had a taste of the unexpected last year when equities and bonds became sharply positively correlated. While many would like to view it as a one-off, the truth could be more complicated.

Brendan Paul, portfolio manager and head of multi asset for Atrium Investment Management, believes that the likelihood of structurally higher inflation in the coming years poses greater potential risk of this positive correlation occurring again. That threat turns our traditional notions of portfolio construction and diversification on its head.

“With that, you get no benefit from bonds. If equities are falling, bonds are also falling. We think the biggest opportunity in portfolio construction is to be open-minded and not be wedded to traditional portfolio construction,” says Paul.

Paul favours a three-bucket method of construction using growth drivers like equities, preservers like government bonds and diversifiers which includes liquid alternatives. He believes a greater emphasis on the diversifier bucket of investments will be essential to managing the coming decade.

In this edition of Expert Insights, Paul discusses why the next decade of investing looks different to the past, how taking a different approach to portfolio construction could be the biggest opportunity for investors and explains what diversification could look like using the three-bucket model.

Edited transcript:

What is the biggest opportunity for portfolio construction in the coming decade?

The last two decades were the benefit of very low interest rates and very low real yields. A real yield is just the nominal interest rate adjusted for inflation.

For much of the last two decades, we had negative real yields and that benefited that 60:40 portfolio really well. 

If you look at it, the benign inflation environment and low negative yields meant that the correlation between bond and equity prices was slightly negative that whole period. 

That meant the 60:40 portfolio did really well. When equities weren’t doing great, bonds did really well and vice versa.

We think the risk going forward from here is that we’re going to have much higher inflation than we’ve been used to for the past two decades. We realise at the moment it’s heading down, but we think structurally, we’ll have higher inflation. The risk of that is positive correlations between bonds and equities.

With that, you get no benefit from bonds. If equities are falling, bonds are also falling. We think the biggest opportunity in portfolio construction is to be open-minded and not be wedded to traditional portfolio construction that worked very well for the last two decades.

Be open to the idea that you need an extra bucket in there, which is diversifiers as we call it. We think we are really well placed to handle the next decade because we’ve been doing this for just over a decade ourselves with the use of diversifiers. Diversifiers are strategies that we think can perform regardless of the direction of bonds and equities, because you have those in your portfolio.

It’s an exciting time for us in terms of portfolio construction.

What does this mean for portfolio construction and Atrium’s three buckets of investment?

At Atrium, we have three buckets when we consider portfolio construction.

We have our growth drivers, which are our equity investments and our equity like investments, including high yield credit. We have our diversifiers, which are our liquid alternative strategies, and we have our preservers, which are our cash like instruments, our government bonds, our very safe investments.

This structurally different environment that we face going forward places a lot of emphasis on that diversifying bucket because a higher level of inflation brings with it higher macroeconomic volatility. It changes the nature of the relationship between bonds and equities. We go from that environment of the last two decades of having a slightly negative correlation, which was great for 60:40 portfolios, to having a positive correlation. You can't rely on government bonds being that ballast in the portfolio. You really need a solid, well-constructed diversifiers bucket.

In that diversifiers bucket, you’re going to have absolute return strategies. Those absolute returns strategies are going to be able to generate your returns in your portfolio regardless of what’s happening with equities, regardless of what’s happening with bonds and maybe even regardless of what’s happening with foreign currency investments that you might have.

It doesn’t change our approach because we’ve been engaged in this approach for the last decade but we feel really well placed for handling what we see as a different investing strategy going forward.

What should investors be mindful of when thinking about diversification in this way?

I think the most important thing is having conviction in a strategy or an asset that is going to be an absolute return strategy. That involves getting under the hood of the strategy, whether it be an equity-based strategy or a macroeconomic-based strategy and understanding the true drivers of returns of the strategy or asset.

Often investors may think they have a diversifying asset, but in fact, it shares a lot of the risks that might be in their equity portfolio, for example. A good example of one might be property.

For a long time, an office tower was very diversifying. A large office with it’s long-term lease was an asset that looked uncorrelated to equities and bonds. But we’ve seen more recently that those valuations are under pressure and some of the risks that are in those assets are the same risks that are in parts of the equity market and in the bond market with yields going higher.

You really need to get under the hood and understand the strategies intimately in the risks you’re taking on within those strategies and make sure they’re not overlapping with other parts of your portfolio.

Something we feel quite strongly about is that the 60:40 portfolio plus some residential property, for example, which would have been a feature of a lot of investors’ investment portfolios over the last two decades is not the best portfolio to have going forward with higher interest rates and risk around equity markets and bond markets moving together. We think its not a particularly well diversified portfolio at the moment.

Learn more

Brendan and the team at Atrium help investors maximise the benefits of diversification by bringing together a blend of best-in-class investment managers and strategies, carefully selected, and incorporated into a range of professionally managed multi-asset diversified solutions. Visit their website to learn more

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