Many traditional fund managers fail to understand a simple market dynamic that would help them build truly defensive portfolios, according to Anthony Rayner, co-manager of the £268.6m Premier Miton Cautious Monthly Income fund.
Managers who buy bonds to diversify from equities, for example, show a lack of understanding that volatility and correlation levels vary according to the investment environment.
“The more traditional fund managers will be looking for bonds to diversify equities, reflected in the common narrative that bonds are always good diversifiers of equity,” the manager said. “This is also reflected, for example, in the fact that most funds have very little in commodities like gold.”
But they aren’t the only ones who are getting this wrong. Index funds are drawn to have a “material” exposure to government bonds and a bias to longer duration, while funds with a sustainable focus will have a bias against oil, despite it being “one of the best diversifiers from equities” over time.
This tendency leaves investors to choose from a pool of investments funds that are blindly looking at what is working right now to diversify equity risk, rather than what has worked in the past and extrapolating that forward. In other words, people are failing to recognise the wake-up call of 2021, when equities and bonds took everyone by surprise crashing simultaneously.
The two graphs below look back over the past 50 years. The first chart looks at the correlation between US equities, as represented by the S&P 500, and 10-year US government bonds.
Correlation between US equities and US bonds
Source: Premier Miton, Bloomberg Finance L.P and S&P 500
“There are a number of important observations to make. Firstly, there are extended periods when bonds don’t diversify equities and, in fact, bonds have generally only diversified equities during periods of disinflation, that is when inflation risk isn’t elevated,” Rayner said.
“Secondly, in more normal periods, meaning when inflation is elevated, equities and bonds tend to be strongly correlated to each other.”
The second chart looks at the correlation between US equities and the Bloomberg Commodities index.
Correlation between US equities and commodities
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Source: Premier Miton, Bloomberg Finance L.P and S&P 500
In the majority of the same periods where inflation risk is elevated and bonds have been correlated with equities, commodities have proven to be “a pretty good diversifier”, the manager noted.
“Intuitively it makes sense that commodities do well when inflation is elevated, even if equities and bonds don’t. Oil and foods are often primary drivers of inflation spikes, while gold often responds positively as an inflation hedge,” he said.
“This has been borne out in more recent times, which both charts show, as the environment has been characterised by inflation, so bonds have been correlated to equities, whilst commodities have provided some diversification.”
Recognising that the same asset class has not always been the best diversifier of equity risk over time is particularly important for a defensive portfolio but also for all multi-asset portfolios, as investors understand the importance of having a defensive element to their portfolio.
“For most multi-asset portfolios, equity beta tends to be the biggest portfolio risk. Therefore, from a risk perspective, one of the most pertinent questions is how, and by how much, to diversify equity beta,” he said.
“It might sound blindingly obvious that the environment drives an asset class’ behaviour, but all too frequently investors do not follow this logic through when it comes to the practice of portfolio construction,” Rayner concluded.