 [5 min read, open as pdf for full article]
Equity markets endured a triple shock in the first quarter of 2022: a dramatic steepening of the likely path of interests, multi-year high inflation levels and a horrific war unleased in Ukraine. The traditional rational for including nominal bonds was to provide steady income, lower but positive returns, and diversification – a place of safety in periods of market stress. In face of rising inflation and rising interest rates, nominal bonds are providing none of these portfolio functions. Indeed in 1q22 not a single bond exposure delivered positive returns, and over 12 months only inflation-linked exposures delivered positive returns. Open as pdf for full article CPD Webinar Alternatives to Bonds in a Portfolio  [5 min read, open as pdf]
Find out more on this topic in our upcoing CPD webinar
For investors with long time horizons who want an all-equity portfolio, there is no shortage of low- cost global equity ETFs. In cricketing terms, when sunshine’s guaranteed, a grass pitch works just fine. But when time horizons are shorter and risk control matters more – as in these uncertain times - a multi-asset approach might make better sense. Put differently, when the weather is changeable or extreme, an all-weather pitch makes more sense. It’s the same for investments. In these times of market volatility, rising interest rates and inflation pressure, we explore three different types of multi-asset strategy: the 60/40 portfolio, the “Equal Risk” or all-weather portfolio, and the “Equal Weight” or Permanent Portfolio. The problem with 60/40 The traditional multi-asset portfolio is the so-called “60/40” portfolio – where 60% is invested in equities, and 40% is invested in bonds. This is the “classic” multi-asset strategy. The idea being that you can combine higher risk and return from equities with lower risk income from bonds. A 60/40 portfolio can be constructed with just two ETFs. 60% in a global equity ETF like SSAC (iShares MSCI ACWI UCITS ETF) or VWRP (Vanguard FTSE All-World UCITS ETF); and 40% in a bond ETF – for example AGBP (iShares Core Global Aggregate Bond UCITS ETF GBP hedged) for those wanting global bond (hedged to GBP) exposure, or IGLT (iShares Core UK Gilts UCITS ETF) for those wanting UK government bond exposure. Or you can make it more and more granular. But this traditional 60/40 model is under pressure, and the suggestion currently is that the 60/40 portfolio is now “dead”. Why is this? Well because for the last 30 years or so, we’ve lived in a world where inflation and interest rates have been trending down – which is doubly good for bonds. But now we are now in an economic regime where both interest rates and inflation are starting to trend up – which is doubly bad for bonds. The other problem with 60/40, is that in times of market stress, the correlation between equities and bonds increases, meaning that bonds lack the diversifying power they may have had in the historical long-run, at a time when it is needed most. In summary: the advantage of this approach a 60/40 portfolio is easy to construct, and is a classic “balanced” portfolio. The disadvantage of this approach is that bonds are facing an uphill struggle for the next few years, so may not be as “balanced” as you would want. The all-weather portfolio The all-weather portfolio concept is that of a multi-asset portfolio that is designed to deliver resilient, consistent performance in different market regimes, or “whatever the weather”. The term and idea was pioneered by Ray Dalio of Bridgewater Associates (which was established in 1974, shortly after Nixon took the US Dollar off the gold standard) and is designed to answer the question: “What kind of investment portfolio would you hold that would perform well across all environments, be it a devaluation or something completely different?”[1]. Dalio and Bridgewater’s all-weather portfolio assumes equal odds of any of four market regimes (rising/falling growth/inflation) prevailing at any time. This approach created and pioneered what is also referred to as a “Risk Parity” approach to investing. The concept of risk parity requires some additional explanation. A classic 60/40 equity/bond allocation results in a portfolio where over 95% of overall portfolio risk comes from the equity position, and the balance comes from the bond position. In short, the asset allocation drives portfolio risk, and while a portfolio may be balanced in terms of asset allocation, it is imbalanced in terms of risk allocation. Risk parity reverses the maths: it means that each asset class contributes equally to the overall risk of a portfolio. This is why it is also known as an “Equal Risk” approach. But as risk is dynamic, not stable, the asset weights must adapt to keep the risk allocation stable. UK investors can build their own all-weather portfolio using four to six ETFs representing broad asset classes: global equities, UK equities, gilts, property, gold and cash equivalent, depending on complexity. In order to keep the risk allocation stable, the asset weights might need to change each month to reflect the changing risk and correlation relationships of and between those asset classes. In summary: the advantage of this Equal Risk approach is that a portfolio is truly diversified from a risk contribution perspective. The disadvantage of this approach is it requires a regular change of weights to reflect changing short-term volatilities and correlations. The Permanent Portfolio The permanent portfolio is a concept pioneered by the late Harry Browne, a US financial adviser, in his 1999 book “Fail-Safe Investing”. It has many adherents in both the US and the UK, but to date it is only really in the US that one can find ‘Permanent Portfolios’ on offer, something UK investors seem keen to change. The concept is similar to the all-weather portfolio, but in a more straightforward format. Rather than trying to target an “Equal Risk” contribution with changing asset-class weights, the Permanent Portfolio is a simple Equal Weight approach to four main asset classes to reflect different market regimes, so that whatever the regime, the portfolio has got it covered. Browne outlines four market regimes[2], and related asset exposure for that regime:
US versions of this strategy use US equities for the equity exposure and US treasuries for the bond exposure. So what would a UK version look like? We constructed a Permanent Portfolio for UK investors using 4 London listed ETFs: SSAC for global equities, IGLT for UK bonds, SGLN (iShares Physical Gold ETC) for gold and ERNS (iShares GBP Ultrashort Bond UCITS ETF) for cash equivalents for some additional yield over cash that will capture rising interest rates. In summary: the advantage of this Equal Weight approach is its simplicity and low-level of maintenance required. The disadvantage of this approach is that it disregards short-run changes in volatility and correlation that are captured in the Equal Risk approach. How do they all compare? Obviously the strategies vary from each other. To evaluate performance, we have created research portfolios for both these strategies. What becomes apparent is that the outperformance of these low-cost, equal-risk and equal-weight all-weather and permanent portfolios looks relatively attractive when set against many more complex (and expensive) “all-weather” absolute return funds. Find out more about our All-Weather Portfolio of ETFs for UK investors. Find out more about our Permanent Portfolio of ETFs for UK investors. See all our Research Portfolios Attend our CPD webinar on this topic [1] https://www.bridgewater.com/research-and-insights/the-all-weather-story [2] Harry Browne, Fail-Safe Investing, (1999) Rule #11 Build a bullet-proof portfolio for protection (pp.38-49)  [5 min read, open as pdf]
In our 2022 outlook, we explained why inflation will remain hotter for longer and will settle above pre-pandemic levels. Advisers should consider how to adapt portfolios for inflation across each asset class – equities, bonds and alternatives. Research demonstrates how different asset classes exhibit different degrees of inflation protection over different time-frames. Equities therefore provide a long-term inflation hedge.
In this article, we explore how to adapt portfolios for inflation within and across each asset class: Equities, Bonds and Alternatives. For full article, read as pdf  [7 min read, open as pdf for full report]
[See CPD webinar on risk-weighted diversification]
The challenge A 60/40 portfolio delivers asset-based diversification: it represents a mix between equities and bonds. However although a 60/40 portfolio reduces market beta, it does not provide “true” (risk-based) diversification: for example, a 60/40 portfolio, as represented by the Elston 60/40 GBP Index remains 97% correlated with Global Equities. This problem only increases in stressed markets where correlations between assets increase, as we saw in 2020. Risk-weighted strategies for “true” diversification Risk-weighted stratetgies, which represent multi-asset portfolios constructed towards a specific portfolio risk outcome, enable an alternative, differentiated approach to investing and for incorporating "true“diversification”. We look at the following risk-based strategies in our analysis: Risk Parity, Max Deconcentration, and Min Variance. These are summarised in more detail in the report. Comparing asset-weighted vs risk-weighted strategies How can we compare the efficacy of traditional asset-weighted strategies (e.g. 20%, 40%, and 60% equity/bond strategies), vs these risk-weighted strategies? One approach would be to compare the efficacy of risk-based strategies vs asset-based strategies from the perspective of 1) capturing equity returns, whilst 2) providing “true” diversification as measured by decorrelation impact (the reduction in correlation relative to global equities). In summary, the findings are that a Risk Parity strategy captured a similar level of equity returns as a 40% equity strategy, but with almost twice the level of decorrelation, meaning it delivers far greater “true” diversification relative to an asset-weighted strategy with similar return profile. Over the 5 years to December 2020, a 40% Equity strategy captured 44.3% of global equities annualised returns and delivered a correlation reduction of -22.3%. By contrast, a Risk Parity strategy captured 48.5% of global equity reutrns, and delivered a decorrelation of -44.8%, relative to global equities. So for portfolio constructors looking to deliver “true” risk-based diversification, whilst maintaining exposure to risk assets for the potential for returns, incorporating a risk-based strategy such as Risk Parity, Max Deconcentration, or Min Variance could make sense depending on portfolio risk budgets and preferences. For full quarterly performance update, open as pdf |
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