The negative correlation between shares and bonds has shifted to the point where it can no longer be relied upon to offset risk in a portfolio and requires investors to adopt a range of alternative investment strategies, according to an international investment manager.
Janus Henderson Investors head of diversified alternatives David Elms said the rise in interest rates, in response to inflation, represents a significant shift from what investors have experienced for more than a decade and raised questions around what they should do when the pricing of risk is changing.
“The correlation between bonds and equities has been persistently negative since the late 1990s,” Elms observed.
“A traditional bond/equity portfolio has benefitted from the natural risk offset created by that negative correlation.
“In a low-yield environment, in inflationary times, the correlation between bond and equity prices is less certain and your typical 60/40 portfolio is not going to look, or behave, in the same way as it has before.
“The question now is if we believe we are in a regime where inflation is likely to remain persistently above 2 per cent in the economies we are focused on, [are we at] the point at which the correlation between bonds and equities seems to become less certain, potentially flipping from negative to positive?”
Given this scenario seems likely, he suggested investors now had to find ways to stabilise their portfolio and consider alternative strategies because during crisis periods assets usually became correlated.
“Diversification works in normal market environments, when arguably it is not needed, but tends to fail in a crisis when its benefits are most needed,” he explained.
“This is not necessarily because portfolio construction is broken, but rather because you tend to see herding from investors during periods of acute uncertainty.”
Elms noted that during these periods investors should have a liquid portfolio that can use different strategies that are not correlated, such as following trends, investing in macro themes or benefitting from volatility to generate returns while offsetting portfolio risks.
“We would argue that the shape of returns is as important as their simple magnitude. This shape can be vital to investors who are looking to retire or those who can’t afford to risk a significant loss of value,” he said.
“Given the scale of change and uncertainty markets have experienced over the past few years, you have to ask yourself if you can afford to focus solely on return maximisation, without considering the benefits of risk management and protection strategies.”
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