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.

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%

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