Managing portfolio risk used to be a simpler task; first set your allocation to equities and then diversify risk through an allocation to bonds. This is what has become commonly known as the 60:40 portfolio. This method has worked brilliantly well as the ‘low risk’ bond diversifier in the portfolio has been in a 30 year bull trend so you’ve made positive returns from both parts of your portfolio. Bonds have also done a decent job in reducing portfolio drawdowns during significant market crashes such as the Global Financial Crisis or the recent COVID-19 crash.

The idea that an allocation to bonds within a portfolio can help reduce your risk relies on making assumptions about correlation, or in other words, how the prices of both asset classes will interact; if bond prices go up when equity prices go down, you reduce risk, simple enough. What happens when bond prices go down at the same time as equity prices, like we saw in the first quarter of the year? Well, you lose in both parts of your portfolio and suddenly that 60:40 portfolio allocation doesn’t look so clever.

Many commentators have wrongly called the end of the bond bull market. Whether August 2020 truly marks the top of the market for government bond valuations or not remains to be seen, but what we can say with certainty is that bonds have done a very poor job in reducing portfolio drawdown so far this year. Persistent, high inflation has forced the hand of central banks and they have started to reverse the era of ultra-loose monetary policy through raising interest rates and signalling the end of quantitative easing. It seems reasonable that as the asset class that has directly benefitted the most from loose monetary policy, bonds stand to suffer as monetary policy is tightened.

As portfolio managers there is clearly a lot to contend with in the current environment; including the risk of further escalation in Ukraine, the Covid lockdowns in China, and growing fears that central banks will be unable to avoid economic slowdown as they continue to grapple with strong inflation. Persistent, elevated volatility we are experiencing in financial markets highlights the importance of a flexible risk management framework.

Our approach to managing risk is very different to the traditional equity/bond allocation in a 60:40 portfolio, we take a bottom-up approach rather than top-down, focussing on building a portfolio of diversified strategies from the investment company and derivatives universes. Both these universes are broad which affords a high degree of flexibility to the fund mandate. We look to deliver a consistent low volatility return profile and positive returns over the medium term, (three year periods) in any market conditions, which means our primary focus has to be on managing risk.

The starting point is to seek out investments that we believe will have a low sensitivity to the broader macro economy, which naturally leads us to alternative asset classes and using derivatives to structure investments with low correlation to traditional asset classes such as equities and bonds. This helps the fund remain defensive when financial markets experience periods of high volatility usually associated with drawdowns.

The fund is built around a core of defensive, bond alternatives that offer the potential of attractive risk-adjusted returns versus the broader fixed income universe. These are investments with bond-like characteristics that tend to have a relatively short maturity profile and low sensitivity to broader market moves. They are investments that have a more predictable return profile over time as they display a pull to par effect, this generates a stable core to the return profile of the fund.

We also have an allocation to alternative investments which are investments outside of the more conventional asset classes of equities and bonds. Traditionally the largest alternative asset classes have been hedge funds, real estate, infrastructure and private equity but in recent years the range of opportunities, and how you can access those, has widened significantly. Examples of new asset classes we have recently gained exposure to include music royalties, energy efficiency projects and digital infrastructure. The performance of alternative investments tends to be less sensitive to broader economic and financial market conditions and therefore can be a useful diversifier for portfolios. In fact some positions, through the use of derivatives, may benefit from market volatility and therefore perform strongly while conventional asset classes are under stress. This has the effect of dampening overall portfolio volatility resulting in a smoother return profile for investors.

Diversification is the primary risk management tool available to many multi asset fund mandates, this relies on historic correlations to balance equity portfolios with allocations to bonds, cash or even gold. When these correlations break down, the theory on which these portfolios are modelled and structured falls down. If your diversifying assets lose value at the same time as your equity portfolio, as has been the case with bonds this year, then the choice you are left with is to reduce the riskier parts of your portfolio and hold more cash. This clearly reduces risk but at what cost to the potential return of the portfolio?

Whilst diversification, through an allocation to alternatives, plays an important role, having the flexibility to use derivatives means risk can be managed in a more targeted way through expressing bearish views on markets. We actively manage a combination of reactive portfolio hedges with investment strategies that are designed to perform in prolonged market drawdowns or tail risk events such as the COVID-19 crash. This means we are not forced to hold assets we don’t want to. Having that flexibility is an important tool at a time of such high uncertainty and volatility in financial markets.