For the loser now
Will be later to win
For the times they are a-changin’
Bob Dylan’s lyrics resonate today against a backdrop of social and political unrest unlikely any time seen since he penned them. In 1964 Dylan foresaw changes that would sweep away the norms of the 1950s and shake society’s very foundations.
It feels trite to apply Dylan’s masterpiece to finance, but even in the mundane world of investing, investors must now also recognize that the times are ‘a-changin’.
For decades, the balanced portfolio has been the workhorse of asset allocation. Sixty-forty, representing the average allocation between stocks and bonds over the lifetime of the representative investor, has been accepted as the most appropriate tool to diversify portfolios and smooth out the impact of market volatility on investors’ pools of assets.
The reasoning was simple. Stocks and bonds offered positive inflation-adjusted returns over the long run but were weakly correlated with one another. Periodic losses in one part of the portfolio would be offset by gains in the other. On average, a well-diversified portfolio provided the only ‘free lunch’ in finance, namely higher average returns for a given level of risk (volatility) relative to any other mix of assets.
But that free lunch was only on offer if stocks and bonds each delivered positive returns in excess of inflation and, on average, compensated one another during periods of market weakness. That’s no longer the case.
Today, bond yields in all major economies are well below rates of actual or expected inflation. That’s particularly true in Japan, Germany or Switzerland, where long-term nominal government bond yields are negative. But even in the US, where the ten-year Treasury yield is around 0.70%, the inflation-adjusted yield is roughly minus one percent. Government bonds are a wasting asset in portfolios.
Moreover, with short-term interest rates at or below the ‘zero bound’, the scope for bond investors to benefit from further declines in yields via falling short rates is limited. That is particularly true for the US, where the Federal Reserve has expressed great reluctance to follow other central banks along the path of negative policy rates.
For prudent investors this is a massive challenge. In the long run, bonds seem destined to lose ground against inflation. In the shorter run, the inability of bond yields to fall much when equities suffer setbacks erodes their usefulness as a portfolio diversifier. The ‘forty’ in many investors’ portfolios, meant to act as ballast in rocky times, now feels like deadweight.
So, if prudent long-term investing is no longer prudent, what is left?
Some might counter that leverage is the answer. After all, both bond yields and bond volatility are subdued thanks to the efforts by central banks to stabilize pandemic-stricken economies. Low volatility, low return instruments are typically good candidates to leverage up in portfolios. Ordinary investors, however, may be reticent or even unable to borrow to boost returns. Leverage also works both ways—it can crater a portfolio if bonds sell off. That’s a risk many investors will be reticent to accept.
What about other asset classes and instruments? One shortcoming they share is poor liquidity. Compared to over $50 trillion in global government notes and bonds, the size of gold, other precious metals, or crypto currency markets is small. Public and private markets for debt, which are larger, suffer from heterogeneity of assets, meaning that any specific bond or debt instrument is small and hence prone to illiquidity. In short, there is no liquid substitute for government bonds in balanced portfolios.
Moreover, many of those instruments offer dubious returns. Gold, for example, is a wasting asset in the long run, steadily losing purchasing power versus inflation, with only episodic outperformance. Crypto-currencies, such as Bitcoin, have proven to be highly volatile—making and losing fortunes for their holders. Accordingly, they merit only small allocations in prudent portfolios. Corporate bond yields are presently very low in historic terms and spreads over government bonds are not generous given an uncertain economic outlook owing to the pandemic. Private credit may offer better returns, but not so juicy when adjusted for its illiquidity.
In a world of negative real bond yields, modern portfolio theory is confronted with its greatest challenge. Yet given a history of innovation, it is likely that the financial services industry will respond with new products and services to address the challenge. As ever, some will fail, and others will prove to have been financial alchemy.
Our hunch, however, is that strategies that target marginal returns, perhaps with leverage and bundled into funds, will be one avenue to replace government bonds as portfolio diversifiers. Examples include ‘alternative risk premiums’, such as strategies that exploit maturity spreads in commodity futures markets. Pattern recognition algorithms, underlying many ‘quant’ strategies are another candidate, as are bundles of long-short pair trades. For any of these approaches to gain long-term traction in a new era of balanced portfolios, however, they will need to produce steady returns in excess of inflation and offer weak correlation with directional moves in global equity markets.
The times, they are a-changin’. It’s in the streets and in social media. Less visibly, it is also in our portfolios. It is time to consider what that means.