Enhancing diversification in a low-yield world

Simple portfolio structures face potential hazards in light of the low interest rate environment, but the good news is that they can be improved.

Why investors need to diversify traditional 60/40 portfolios

Simple portfolio structures face potential hazards in light of the low interest rate environment, but the good news is that there are several options to improve performance.

China's sovereign bonds diversify investment portfolios

From a strategic point of view, Chinese bonds appear to be the best positioned to take on some of the role traditionally played by developed market debt.

Highlights

  • The ability of developed market bonds to protect portfolios from growth shocks is challenged by the low level of yields and proximity of central bank policy rates to their effective lower bounds.
  • Most investors cannot resolve this issue by adopting a more defensive posture, as this would introduce an obstacle to meeting return and income objectives.
  • Bonds remain an important component of a well-balanced portfolio, but we recommend that investors take steps to diversify their suite of safe haven assets to improve the resiliency of multi asset portfolios moving forward.
  • From a strategic point of view, Chinese bonds appear to be the best positioned to take on some of the role traditionally played by developed market debt. The incorporation of alternative assets to portfolios may also improve income generation, diversification benefits, and the risk/reward profile.
  • Tactically expanding liquid diversifying assets to parts of the foreign exchange and commodities markets that share some price characteristics with US Treasuries may help produce more robust drawdown mitigation.
  • Incorporating explicit risk control solutions that dynamically manage drawdown risk may enable investors to increase exposure to asset classes with higher expected returns.

The longstanding ability of developed-market bonds to provide positive real risk-free returns and reliably robust performance during equity market drawdowns has been eroded by decades of success.

Bond yields in advanced economies are approaching an effective lower bound, making the need to upgrade your asset allocation more urgent.

A multi-faceted approach to address this challenge includes increasing exposure to Chinese sovereign debt and alternative assets to improve the medium-term risk/reward profile of a portfolio, adding macro-aware liquid diversifiers that share some return characteristics with US Treasuries, and utilizing strategies that more directly control for risk, volatility, and drawdowns.

We believe that investors would be well-served to adopt such a multi-asset approach that uses all the tools at their disposal: a strategic asset allocation to provide improved risk/return outcomes over the long-term, a flexible, creative tactical asset allocation program or overlay to mitigate drawdown risk, and systematic, outcome-oriented structured solutions to more precisely manage the volatility associated with equity exposure.

An overview of our expected returns across global fixed income and equity universe, as well as commodities and hedge fund strategies, indicate there is merit in shifting the nature of defensive exposure in multi asset portfolios. These forecasts, which embed expectations for cross-asset correlations, suggest that five and ten-year returns and Sharpe ratios will be superior for portfolios that reduce developed market sovereign debt in favor of Chinese and other emerging-market government bonds compared to US or global 60/40 structures. So too does increasing exposure to alternative assets relative to bonds and stocks. Meaningfully improving Sharpe ratios when the starting point is an already diversified portfolio is a difficult achievement.

Exhibit 5: Expected returns for a range of portfolios

Expected Returns

Expected Returns

Global 60/40

Global 60/40

Global 60/40 (10% tilt to Chinese, EM debt)

Global 60/40 (10% tilt to Chinese, EM debt)

50% equities, 25% bonds, 25% alts

50% equities, 25% bonds, 25% alts

50/25/25 (10% tilt to Chinese, EM debt)

50/25/25 (10% tilt to Chinese, EM debt)

Expected Returns

5-year Geometric Return

Global 60/40

4.5%

Global 60/40 (10% tilt to Chinese, EM debt)

4.8%

50% equities, 25% bonds, 25% alts

5.7%

50/25/25 (10% tilt to Chinese, EM debt)

5.9%

Expected Returns

5-year Sharpe Ratio

Global 60/40

0.46

Global 60/40 (10% tilt to Chinese, EM debt)

0.48

50% equities, 25% bonds, 25% alts

0.52

50/25/25 (10% tilt to Chinese, EM debt)

0.54

Expected Returns

Standard Deviation

Global 60/40

10.5%

Global 60/40 (10% tilt to Chinese, EM debt)

10.5%

50% equities, 25% bonds, 25% alts

11.7%

50/25/25 (10% tilt to Chinese, EM debt)

11.7%

Read more

 

Asset Management services and solutions in your location

Please select your region

 

For further information on what we can offer you, please get in touch.

Important legal information

To proceed, please confirm that you are a professional client / qualified / institutional investor or US retail clients and investors.

Views and opinions expressed are presented for informational purposes only and are a reflection of UBS Asset Management’s best judgment at the time a report or other content was compiled. UBS specifically prohibits the redistribution or reproduction of this material in whole or in part without the prior written permission of UBS and UBS accepts no liability whatsoever for the actions of third parties in this respect. The information and opinions contained in the content of this webpage have been compiled or arrived at based upon information obtained from sources believed to be reliable and in good faith but no responsibility is accepted for any errors or omissions. All such information and opinions are subject to change without notice but any obligation to update or alter forward-looking statement as a result of new information, future events, or otherwise is disclaimed. Source for all data/charts, if not stated otherwise: UBS Asset Management.
Any market or investment views expressed are not intended to be investment research. Materials have not been prepared to address requirements designed to promote the independence of investment research and are not subject to any prohibition on dealing ahead of the dissemination of investment research. The information contained in this webpage does not constitute a distribution, nor should it be considered a recommendation to purchase or sell any particular security or fund. The materials and content provided will not constitute investment advice and should not be relied upon as the basis for investment decisions. As individual situations may differ, clients should seek independent professional tax, legal, accounting or other specialist advisors as to the legal and tax implication of investing. Plan fiduciaries should determine whether an investment program is prudent in light of a plan's own circumstances and overall portfolio. A number of the comments in the content of this webpage are considered forward-looking statements. Actual future results, however, may vary materially. Past performance is no guarantee of future results. Potential for profit is accompanied by possibility of loss. 
© UBS 2021 The key symbol and UBS are among the registered and unregistered trademarks of UBS.

Reset