While this may increase the expected return of the portfolio (and indeed, lead to a higher return in the event of no sharp falls in equity markets), it is unlikely to provide the diversification benefit being sought.
It is like buying an insurance policy that does not cover the key risks. You save money unless you need the cover.
This is especially relevant for more cautious portfolios as the clients making these investments are likely to be more sensitive to losses.
As these portfolios tend to be dominated by bonds, the return difference achieved by investing in higher risk bonds can be significant, but they may not meet their diversification requirements in the event of a sharp fall in equity prices.
When thinking about risks for diversifying assets, we need to move beyond the specific risks associated with the bond, such as default, and focus on the risks of the assets we are seeking to diversify.
The challenge here is to ensure that the risks of the diversifying asset are not correlated with those that you wish to diversify.
As significant falls in equity prices tend to be linked to broader macro-economic events, the nature of this event will determine whether particular assets provide useful diversification.
We must therefore think in terms of scenarios and consider how each scenario may impact the portfolio.
When compiling these scenarios, it is important that they are grounded in reality. The best indication of how asset classes will behave is provided by long-term historic data.
Which bonds are better for protecting against inflation?
When we approach the assessment of diversification benefit in this way, it is noticeable that the data frequently provides counter-intuitive results.
For example, using data that goes back to the 1970s, high-yield bonds tend to deliver higher returns than Treasury inflation-protected securities (Tips) during periods of high inflation – although they deliver lower returns when inflation is very high.
Less surprisingly, UK gilts tend to deliver far higher returns than either high-yield bonds or Tips in the event of a recession.
Successful diversification therefore is dependent on both an understanding of how assets will behave in the various scenarios and the likelihood of the scenario occurring. The role of the portfolio manager is therefore to weight the scenarios as well as the eventual portfolio.
However, when analysing and weighting these scenarios, it is important to avoid overconfidence in the data.
The infrequency of significant events, combined with the constant innovation in financial markets and the relatively short history of comprehensive financial data means that we have a limited data set from which to draw these conclusions.
