Henderson: The elusive orthogonal

Does anyone actually need more than two asset classes in their portfolio? After all, for a period of time that stretches back beyond the careers or memories of most investment professionals, a balanced portfolio of stocks and government bonds has given investors an almost unbeatable risk-adjusted return. This kind of portfolio also has the added benefit of being entirely liquid, so for anyone disposed to dynamically flex their bond/equity allocations they can do so easily and at a very low cost. Alternatives, on the other hand, can be much less liquid, be expensive and can have a tendency to be highly correlated to equities, exactly when you don’t want them to be.

Government bonds versus cash

Government bonds have benefited from both a multi-decade decline in interest rates that began in 1981 and their status as a liquid, ‘safe-haven’ asset class: a home for capital that periodically flees volatile equity markets. While it is hard to dispute some of the safe-haven characteristics of government bonds – barring an extreme event, you will receive coupons and be repaid your principal –  the ground seems much shakier when it comes to fundamentals and technicals. In other words, yields have never been lower, government debt levels never higher, and benchmark duration never longer (ie, more expensive and riskier than ever), while central banks are stepping back and inflation is ticking up (ie, effectively, the biggest buyer in town is retreating and the real value of your income and capital will in all likelihood be horribly eroded). When faced with the decision of which asset class genuinely offers some safety in a risk-off market, I would opt for zero yield and no duration (cash) rather than zero yield and 8-10 years of interest rate risk (government bonds).

Additionally I would have some gold but, while the precious metal has some great hedging characteristics, I ascribe to it no expected return. Crucially I expect all the other alternatives in my portfolios to generate attractive risk-adjusted returns in a variety of market scenarios, as well as offering various levels of diversification. (This might sound a bit obvious but, at these levels, government bonds offer no returns, plenty of risk, and a perhaps misguided assumption of ongoing negative correlation benefits.)

Searching for true diversification

Alternatives should be viewed differently and each asset class/strategy gauged on its own merits. Some alternatives – for example, private equity, directional hedge funds, ‘specialist’ credit funds such as collateralised loan obligation (CLO) strategies – should be expected to behave in a very similar manner to equities and therefore treated from a risk standpoint in almost the same way. Then there are alternatives that have the potential to look very different to stock markets but can at times of stress also be almost indistinguishable: think commodities and property. And finally there are strategies and asset classes which should have a negligible correlation throughout the cycle, such as market-neutral and merger arbitrage funds, social infrastructure and certain alternative risk premia, such as commodity curve plays or dispersion trades.

It is these latter strategies that are, in statistical parlance, orthogonal* in nature and should add true diversification to a portfolio. The others can be lowly correlated at times but are fairly reliably positively correlated to equities when you would rather they weren’t. My portfolios are full of alternatives (and cash) at the moment, not because of some vague hope that they will bail me out when equities correct, but because I see little value in mainstream stocks and bonds now, and genuine opportunities in some less mainstream assets and in strategies run by managers with excellent track records in generating returns that are not entirely dependent on markets trending ever upwards.
 
*Orthogonality is a term used loosely in statistics to mean non-correlation; in an investment context we use orthogonal here to signify non-correlating strategies or assets.

Die Wertentwicklung in der Vergangenheit ist kein zuverlässiger Indikator für die künftige Wertentwicklung. Alle Performance-Angaben beinhalten Erträge und Kapitalgewinne bzw. -verluste, aber keine wiederkehrenden Gebühren oder sonstigen Ausgaben des Fond.

Die Informationen in diesem Artikel stellen keine Anlageberatung dar.