Third is adapting the risk exposure within the bond allocation. This means considering credit quality, duration and currency. Credit quality (the relative riskiness of corporate bonds relative to government bonds) means adapting the bond portfolio to the outlook for widening or narrowing credit spreads relative to government bonds based on the outlook for corporates’ business health.
Duration (sensitivity to changes in interest rates) means adapting the bond portfolio to the outlook for rising or falling interest rates and the evolving shape of the yield curve. Currency means considering whether to hedge overseas bonds back into sterling or leave them unhedged, based on the prospects for sterling relative to that overseas currency.
In the long run these adjustments may not make a material difference but in the short term - as we were reminded in 2022 - the duration control of a bond portfolio matters hugely and can be the difference between clients getting good or poor outcomes.
What about alternatives?
A final layer of potential adaptation is to consider the split within the non-equity portion of a portfolio - namely between bonds and alternatives.
We define alternatives as anything that isn't equities, bonds or cash. Naturally there are some alternatives that are higher-risk like commodities, and some that are lower risk like a large proportion of absolute return funds. Adapting the non-equity allocation between bonds and alternatives became increasingly important when the outlook for inflation was on the rise.
In those conditions when real inflation-adjusted yields are negative, it means bonds will fail to hold their value in real terms, hence a higher allocation to alternatives makes sense, albeit with a keen focus on risk control. It was this that led our calls to radically deallocate from bonds in the face of rising interest rates and inflation in 2021.
If the inflation outlook is moderating and the real (inflation-adjusted) yield on bonds is positive, then it makes sense to have a higher allocation to bonds, but still use alternatives as diversifiers. This reflects our current positioning today.
A balance has to be struck between long-run risk return considerations, and short-run performance experience. Not to actively manage the risk of a portfolio is to be asleep at the wheel. Over-trading a portfolio can be counterproductive too. Establishing a disciplined approach to adaptive asset allocation, as a form of active risk management, is prudent, and we think is expected by clients.
We think it's wrong that an evidence-based approach to investing has become synonymous with doing nothing. Indeed, who would rationally pay for a set-and-forget approach to investing? For those wishing to consider all the evidence, there is no shortage of research showing that tactical asset allocation can help mitigate portfolio risks in the short to medium term.
