Strategic portfolio hedging in the new market environment
By Jared Gross, Head of Institutional Portfolio Strategy
- Fixed income likely won’t be able to deliver the same level of portfolio protection as it has in the past. Where de-risking is not an option, it may be worth considering other forms of diversification.
- Effective portfolio diversification has been underpinned by long-held assumptions about correlations between stocks and bonds, but conditions have changed: With bonds’ potential gains limited and opportunity costs high, we suggest new ways of thinking about building in downside protection.
- To protect against inflation while maintaining returns, assets—such as real estate, infrastructure and transportation—with higher return potential and inflation sensitivity may deserve a larger allocation.
First rule of investing: Diversify. Second rule of investing: Stay invested.
A prudently diversified portfolio should balance return and risk effectively, generating long-term returns with limited downside risk. Further, long-term returns on risk assets should exceed inflation by a comfortable margin, leading to gains in real value over time.
But close examination of these assumptions is warranted in the current environment:
- Diversifying fixed income is unlikely to deliver the same degree of protection against equity market volatility as in the past.
- Where outright de-risking is not an option, given the need to generate returns, then traditional portfolio strategies may be running more potential risk for less potential return.
- If liquid markets are expected to deliver lower forward-looking returns, then the margin for error with respect to an upside inflation surprise may be lower than expected.
Under these circumstances, it may be worth considering other forms of portfolio protection, including more direct means of managing equity risk exposure and higher returning core real assets to offset inflation.
EXHIBIT 1: Negative-yielding bond supply has risen in two years from USD 6 trillion to over USD 14 trillion globally
Global value of bonds yielding less than zero
Beyond traditional fixed income duration: Hedging the tails
Return-seeking assets show a high degree of equity factor risk and corresponding exposure to the rare but-painful “left tail” scenario of a severe market draw-down. Additionally, in many market downturns the correlations across asset classes can rise, narrowing the scope of portfolio diversification to only those assets with a reliably negative correlation to equity risk. History shows that the duration risk factor in a bond portfolio has been an effective hedge to equity risk if held in sufficient size to meaningfully offset losses.
However, the current market environment poses a challenge to the traditional role of fixed income duration as a portfolio hedge, in a number of ways:
Correlation assumptions may not hold. While the correlation of equity and duration has been reliably negative in recent years, across history this relationship was positively correlated for extended periods of time. In general, this has been in environments in which rates were rising on the back of rising inflation expectations and, in particular, when accompanied by low nominal growth. Should such an environment recur, the duration hedge could actually make a difficult situation worse.
Bonds may provide less protection going forward. Treasuries are trading at or near record low yields across the curve, and globally a significant portion of government bond yields are negative. While it is a truism that U.S. rates could always fall further, the reality is that the hedge potential of most U.S. fixed income is constrained by low yields. Further positive returns are less likely going forward and almost certainly smaller in magnitude.
Investors should consider opportunity costs. The most significant cost of the hedge portfolio is the opportunity cost associated with placing capital in a strategy that, based on forward-looking return expectations, is unlikely to deliver returns much in excess of 1%–2% over a long horizon.
Improving the hedge solution
How can investors improve portfolio protection, given that a traditional fixed income hedge’s effectiveness is uncertain, the potential gains are limited, and the cost is high? Potentially by:
- Not abandoning the fixed income hedge entirely. A concentrated position in long-duration Treasuries takes advantage of the higher yields available further out on the yield curve and still has the potential to register meaningful gains in a market sell-off.
- Looking to reduce exposure to equity beta at the portfolio level. Consider shifting some equity exposure to other return-focused investment categories across public and private markets (Exhibit 2). Asset classes such as securitized, high-yield and emerging market debt; preferreds; private credit and infrastructure are among those that currently can offer reasonable higher yields with lower volatility than equity.
- Lowering hedges’ volatility. Consider moving some equity exposure to lower volatility strategies or to hedged equity strategies that use options to avoid the more extreme moves in the market.
- If you’re paying for the insurance, use it. Portfolios with more direct hedges can maintain a higher level of equity risk. Portfolios with larger allocations to less volatile equity alternatives need smaller fixed income allocations to serve as a counterbalance. Either way, the long-term goal of return generation should not be lost amid concerns about the current environment.
EXHIBIT 2: Alternative asset classes can provide a higher return potential than traditional hedging strategies
Recent asset class yields
Protecting a portfolio against inflation is a long-term goal – avoiding the slow erosion of value as well as the negative impact of higher nominal interest rates. Today, this risk is compounded by the exceptionally low level of current interest rates, which provide little or no margin for error for fixed income portfolios and have at the same time been broadly supportive of higher equity prices. So, while the probability of an inflation surprise might be low, the consequences could be severe.
In an inflationary environment we can generalize about the performance of various asset classes: Fixed rate bonds will perform poorly, stocks will likely be volatile and real assets will do best. For a portfolio to outearn inflation, investors have a few opportunities:
- Adjust fixed income positioning. Traditional fixed income portfolios might pivot to lower duration or floating-rate strategies, and to those with a higher spread content. (Long-duration bonds may be retained for hedging purposes, as discussed above.) Active management can play a key role in terms of curve positioning and identifying credits that could benefit from rising prices.
- For equity strategies, it may be best to leave active discretion with portfolio managers who have the capacity to understand individual firms’ exposure to the components of price inflation and (presumably) higher interest rates. Broad passive cap-weighted benchmarks that have enjoyed a tailwind from disinflation and lower interest rates could be a concern.
- Real assets likely deserve a larger allocation. However, selection among real assets is key. The opportunity cost is high for large allocations to very low-yielding assets such as TIPS, commodity indices or gold. REITS may play an interesting role, as they can deliver higher levels of inflation-linked return (though with some correlation to the broader equity market). Core real assets1—such as core real estate, infrastructure and transportation—offer the prospect of significantly higher returns alongside business models that directly embed price-level resets.
Bending the rules (a little)
The rules of investing hold that maintaining a diversified portfolio across time is likely to provide the best long-term outcome. But the long term is actually a sequence of specific market environments that must be taken as they come. When conditions pose unusual risks to the traditional approach, we recommend adjusting accordingly.
The need for returns has not diminished, though it will be more challenging to realize them. The risk of volatility has not diminished, though it will be more challenging to manage. Fortunately, investors are not forced to remain passive in the face of changing markets; they can apply balance and common sense to improve the chances of making good on their objectives.
When the environment warrants broadening your hedge—with fixed income likely unable to deliver the protection it has in the past and de-risking not an option—it may be worth considering other forms of portfolio protection. And with liquid markets expected to deliver low forward-looking returns and upside inflation a risk, it can make sense to add inflation-sensitive assets.
The steps outlined here can help a diversified portfolio manage through a challenging market environment—not by tossing out the basic rules of investing but by applying them in a more thoughtful manner.
1 We consider core alternatives to be alternative investments that offer a stable source of income at a meaningful premium to core bonds, with yields ranging from 5%–9%-plus, and that at the same time reduce equity beta, improving overall diversification, albeit at a cost of less liquidity.
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