For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Seasoned investors understand the importance of having a defensive element to their portfolio, but what’s the best way to construct that defensive element, or indeed to construct a defensive portfolio?
Starting from first principles, for most multi asset portfolios, equity beta tends to be the biggest portfolio risk. Therefore, from a risk perspective, one of the most pertinent questions is how, and by how much, to diversify equity beta.
In short, it depends. Specifically, it depends on the investment environment, because the environment drives how an asset class behaves (volatility), and how asset classes behave in relation to each other (correlation). It might sound blindingly obvious that the environment drives an asset class’s behaviour, but all too frequently investors do not follow this logic through when it comes to the practice of portfolio construction.
As we reach the ten year anniversary of running the macro thematic Defensive Multi Asset Fund, we have seen time and time again that pragmatism is a good place to start when trying to understand risk. Specifically, looking at what is working now to diversify equity risk, rather than just what has worked in the past and extrapolating that forward.
These two graphs, which look back over the last 50 years, illustrate this point very well. The first chart looks at the correlation between US equities (S&P 500) and US bonds (10 year government), while the second chart looks at the correlation between US equities and commodities (Bloomberg Commodities Index).
There are a number of important observations to make. Firstly, there are extended periods when bonds don’t diversify equity and, in fact, bonds have generally only diversified equity during periods of disinflation, i.e. where inflation risk isn’t elevated. Secondly, in more normal periods, i.e. where inflation is elevated, equities and bonds tend to be strongly correlated to each other. Finally, in the majority of those same periods where inflation risk is elevated and bonds have been correlated with equities, commodities have proved to be a pretty good diversifier of equities.
Source: Bloomberg Finance L.P and S&P 500: 31/12/1974 – 24/05/2024
Past performance is not a guide to future returns.
Source: Bloomberg Finance L.P and S&P 500: 28/09/1973 – 24/05/2024
Past performance is not a guide to future returns.
Intuitively it makes sense that commodities do well when inflation is elevated, even if equities and bonds don’t. Oil and foods are often primary drivers of inflation spikes, while gold often responds positively as an inflation hedge. This has been born out in more recent times, which both charts show, as the environment has been characterised by inflation, so bonds have been correlated to equities, whilst commodities have provided some diversification.
Recognising that the same asset class has not always been the best diversifier of equity risk over time is particularly important for a defensive portfolio, but also for all multi asset portfolios. Indeed, our pragmatic approach to portfolio construction has been a big driver of the strong absolute and relative returns over short, medium and long term time frames for the Macro Thematic range.
However, it’s not so straight forward for many of our competitor funds. The more traditional fund managers will be looking for bonds to diversify equities, reflected in the common narrative that bonds are always good diversifiers of equity, this is also reflected, for example, in the fact that most funds have very little in commodities like gold. Meanwhile, index, or quasi index funds will be drawn to have a material exposure to government bonds, and with a bias to longer duration. Funds with a sustainable bias, on the other hand, will most likely have a bias against oil, despite it being one of the best diversifiers of equity beta over time.
In short, a cursory glance at the ‘defensive’ funds on offer illustrates that many will have a fairly fixed and material exposure to bonds and actually often not be nimble enough to embrace the best diversifier of equities at any given time, whichever asset class that might prove to be.
Anthony Rayner
Premier Miton Macro Thematic Multi Asset Team
