While a mix of government bonds and equities has generally provided the bedrock for a typical asset allocation strategy, the best ways to derisk portfolios in today’s markets favour a rather more sophisticated approach.
Most investment experts are agreed that traditional asset allocation rules are off the table, not least because, as Matthew Morgan, investment director in the multi-asset team at Jupiter Asset Management, says: “Today, developed government bonds yield very little, and have been losing money in recent months.
“Markets are in uncharted territory because central banks and governments are doing more than ever to create inflation and growth, and this could lead to higher interest rates and further losses from government bonds.
“The answer to the problem is to be innovative and dynamic. There are other ways of building resilience into portfolios through the cycle such as using long and short positions in portfolios to access relative value, alternatives, active currency, and volatility. Dynamically evolving through the cycle is also key; setting and forgetting your asset allocation is likely to underperform.”
Diversification and flexibility
Derisking is certainly more challenging these days says Matthew Yeates, 7IM’s head of alternatives and quantitative strategy, pointing to greater use of credit instruments, alternatives such as market neutral strategies, real estate investments and occasional use of specialist fixed income areas that “makes more sense than piling into the historically ‘safe’ havens of government bonds”.
While Douglas Kearney, investment director at Intelligent Pensions, warns that he sees some asset allocations prescribed in industry rules and frameworks suggesting very high exposure to government bonds of circa 40 per cent plus, which “would not be the smartest move right now”.
He says: “There is no instruction manual for dealing with 2020 and 2021 and so diversification and flexibility remain important as the world’s economies recover from the pandemic."
The current phase of the business cycle is of rapidly increasing profits, after a severe downturn, against a background of low but rising inflation, says Tom Elliott, senior investment strategist at Mattioli Woods.
“Investors usually respond to this combination with an overweight position in equities relative bonds. ‘Derisking’ in the current environment, therefore, means positioning portfolios in such a way as to benefit from inflation, or at the least reducing the possible harm that inflation may exert on a portfolio,” he says.
“This means reducing overall exposure to fixed income, since rising inflation will continue to push up bond yields. A switch into asset classes such as gold and equities may be suitable, since they have a better history of retaining their real value in the face of inflation.”
Within fixed income portfolios, derisking might include reducing duration and even building up cash positions with the intention of creating dry powder to re-enter the bond markets when yields have peaked, he argues.
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