Time Again for Outcome Investing?
Our concerns about the equity–bond correlations came to fruition with both equities and bonds decreasing in value significantly over 2022 with many investors struggling with static strategic asset allocations. We make the case that it is evermore important to consider outcome investing and some tactical or dynamic overlays to help protect the value of portfolios.
As we approach the middle of the decade, the 2020s have already delivered two equity bear markets and a rarer bond bear market. What is clear is that the exceptionally smooth and strong performance of almost every asset class from 2010 to 2019 has come to an end. What is less clear is whether investors have recognized these structural changes in their portfolio design.
Looking back, COVID-19, the end of extraordinarily easy monetary policy across key central banks and the return of inflation have been the disruptive forces that re-introduced volatility and unstable correlations across asset classes. While unusually high fiscal deficits in a non-recessionary period have helped support economic activity, and by extension equity prices in 2023 and into 2024, the consequential reduced fiscal firepower to deal with future crises further increases the prospect of elevated volatility and higher equity/bond correlations in the future.
In 2020, we authored a paper questioning whether a traditional 60:40 portfolio would be sufficient to weather the market environment to come and proposed greater focus on outcome investing. Our concerns about correlations came to fruition with both equities and bonds decreasing in value significantly over 2022 with many investors struggling with static strategic asset allocations. We revisit the thesis and make the case that it is evermore important to consider outcome investing and some tactical or dynamic overlays to help protect the value of portfolios in an increasingly volatile and polarized world punctuated by geopolitical and financial market risks.
What to Expect from Remainder of 2020s and Beyond
As we look forward, the prospective returns over the next 10+ years of a 60:40 portfolio based on SSGA’s Long-Term Asset Class Forecasts is around 5.2%. This is in fact a sharp improvement to an average annual return of close to 3.1%, which was the long-term projection in 2021. With the return of inflation and higher government yields across key developed markets, the longer-term prospects for fixed income in the context of a multi-asset portfolio are much stronger than 2021.
Positive Equity Versus Bond Correlation a New Old Dynamic
While prospective returns are now back to more meaningful levels, an important question to ask is does fixed income provide diversification benefits in times of need?
The correlation between bonds and equities has changed over time and, in contrast to the 2000s, has historically been positive more than negative. We previously suggested that in an inflationary environment, the negative correlation between bonds and equities may break down and we can see that this is what has played out in the recent past, as shown in Figure 2.
Stop Dreaming of the Quiet Life
Figure 3 shows the average volatility of a typical 60:40 equity bond portfolio over recent decades. We can see unusually low levels of volatility from 2010 to 2019, a sharp contrast from elevated levels in the early 2000s.
What is perhaps even more interesting is how, since 2020, the average volatility on a 60:40 portfolio has on average shifted higher than the previous two decades. We believe this trend — a normalization toward higher volatility — was overdue. While the volatility levels of 2020s may not sustain, returning to the tranquility of the 2010s is unlikely. Instead, a more elevated volatility regime can be regarded as the new norm.
Less Policy Support in Future
Key central banks around the world are now operating in a higher inflationary environment than what was observed since the early 2000s. In addition, fiscal policy support has been exhausted in the years after COVID-19, which is showing up in high government deficits. This suggests a relatively limited ability for policy makers to step in and ease financial conditions should another crisis come to the fore, implying higher volatility across asset classes and reinforcing the positive equity–bond correlation at the worst of times.
Triggers for Crises All Too Plausible
Our final consideration on expecting a higher volatility regime going forward is geopolitical risk. Just in 2024, a large number of global elections and multiple ongoing wars could be catalysts for heightened volatility. In particular, there are risks of a global supply shock from the conflict in the Middle East — similar to what occurred in 2022 at the start of the Russia–Ukraine war.
The subsequent increase in global energy and food prices triggered stagflationary concerns, which in turn raised long-term rates and reduced the efficacy of government bonds as a hedge in the portfolio. Going forward, although inflation is lower, it still remains above target levels, and considerable rises in energy and food prices could trigger a similar response from the market.
In our Global Marlet Outlook, we had highlighted how armed conflict and violence were increasing globally. The breakdown also highlighted rising interstate conflicts, which reflects an increasingly multipolar and unstable geopolitical backdrop for markets.
Outcome as Determinant of Approach
What is increasingly clear is that investors who take a more passive approach toward their investment strategy are facing considerable challenges in the coming years from:
- Higher Volatility
- Higher Downside Risk
Dealing Directly With the Problem
Absolute target return funds can help address these challenges. For a start, their objective is one that for many investors is the ultimate aim — meaningful absolute return with careful consideration of absolute risk. This style of fund aims to deliver absolute returns, typically in the range of cash +2% to cash +4% p.a., while actively managing risk.
Absolute target return strategies gained huge popularity in the post–Global Financial Crisis era as the 50%–60% fall in equity markets experienced at the time caused some investors to re-evaluate their risk tolerance and seek investment solutions to match their risk and return needs.
As the 2010s progressed, popularity waned, partly on account of performance and partly as the comparator of both equities and bonds went on a resounding winning streak. Managing risk seemed unnecessary when equity market risk levels were so low and receiving absolute returns of cash + 4% seemed unexciting.
The Right Assets at the Right Time
The investment approach for this strategy is to vary portfolio risk according to market volatility. When risk is rising, caution is required, and the strategy moves into safer asset classes. When markets are expected to be calmer, we can comfortably add more growth-seeking assets.
State Street Flexible Asset Allocation Strategy
Our Flexible Asset Allocation Strategy aims1 to achieve a return ranging from Cash + 2% to Cash + 4% with a strong emphasis on risk management. The strategy blends traditional passive exposures with active positioning to enhance returns, while incorporating explicit volatility management techniques to provide a smoother path through time – an attribute that may be more valued in the next decade than the last as general market volatility rises.
Our Flexible Asset allocation strategy combines:
- Diversified market exposures from a range of asset classes
- An explicit market-regime-aware approach to risk management
- Return enhancement from tactical asset allocation and sector selection
- Additional downside risk management via the usage of a tail risk basket of assets.
Evolving Composition
A well-designed strategy also needs to organically evolve over time to ensure objectives can continue to be achieved.
In our Flexible Asset Allocation Strategy, we have a formal annual process to review and incorporate enhancements, and the latest capital market forecasts. Over the years, we have introduced a range of innovations to improve the prospects for returns or to support downside risk management, be that the introduction of new asset classes, tactical models or portfolio construction techniques.
By remaining innovative, the strategy remains less reliant on pure market-based returns and a more balanced burden of weight can be borne by tactical strategies and portfolio construction mechanisms.
Focus on Absolute
Now may be a good time to invest in a strategy with an absolute return objective, one that carefully considers the blend of asset classes, return generation mechanisms and risk management techniques that best achieve the return and risk goals. This will enable investors to earn meaningful returns while providing greater resilience to weather increased volatility over the coming years.