Achieving diversification in rising markets

The reason for the correlation collapsing is quantitative easing – the programme of bond buying by central banks. 

Traditionally, bond yields rise (and so prices fall) when economies are recovering and inflation is returning after a recession, with equities rising in response to the good news. 

At times of market stress, equities fall and bond yields fall (so the price is rising) because investors choose the relative safety of government bonds over the uncertainty of equities. 

The correlation has collapsed as a result of central-bank bond buying, as bond prices remain high even when economic conditions are improving. 

This challenges the rationale for the 60 per cent equity/40 per cent bond portfolio, which is based on the idea that one of those asset classes will always be rising, even as the other is falling.   

The challenge this poses is one of diversification; if both bonds and equities are going up at a time of generally rising markets, how can a client have diversification at the portfolio level with downside protection?

For Ben Kumar, senior investment strategist at 7IM, it is important “to find assets which offset each other. The reality is that in an equity-market crash, bonds will probably still do a job, and when markets are rising, equities are rising.

"The key is to always have something in a portfolio which is losing money. But I think the key is to understand that what has happened over the past decade is an aberration, and I think return expectations in future will have to be lower.

"I think it's important that no one ever has zero in bonds or zero in equities.”

Richard Carlyle, investment director at Capital Group, says the 60/40 strategy remains valid, and notes that it performed well in the aftermath of the global financial crisis.

He says: “On rolling five-year periods, the 60/40 strategy works. There is a very small number of periods where it is negative, but if you invest on a five-year basis, then the 60/40 approach works.

"There is no doubt bonds are expensive, but the way to think of the bonds in the portfolio is as insurance, and right now the insurance seems expensive, but, just as with any insurance product, it wouldn’t seem expensive if your house actually burned down.” 

Suzanne Hutchins, multi-asset investor at Newton Investment Management, says one should consider what the most immediate set of risks to a portfolio are, before deviating from the 60/40 approach.

Her view is that the biggest threat to investor returns in the near term is from inflation, so at the present time her mandates have zero invested in bonds, as this would be the asset class she feels is most likely to suffer in the event of persistently higher inflation.