Collapsing Rates Leave Investors Dangerously Exposed to Equity Risk

The classic portfolio — 60% stocks, 40% government bonds — no longer makes sense

Covid-19 has brought us to a historic turning point in financial markets. A fundamental investment strategy that has protected institutional and retail investors alike for decades — balancing equity risk by holding high-quality government bonds — has finally run its course. When the Fed lowered short-term rates to zero in response to the pandemic, the last shoe dropped.

The implications of this change are huge. For one thing, millions of retail investors have been left largely defenceless, lacking a tried and tested means of diversifying the inevitable risk of holding equities. Similarly, the sophisticated and extremely successful hedge fund strategy known as Risk Parity faces an existential challenge: without meaningfully positive government bond yields, it has been thrust into a harsh environment in which it is unlikely to prosper.

Many investors need to hold equities because of their ability to deliver long-term capital growth above the rate of inflation. One standard way to dampen the well-known volatility of any equity portfolio has been to balance a 60 per cent holding of equities with 40 per cent exposure to government bonds — the classical paradigm of portfolio construction. For the past 20 years, this worked because equities and government bonds were reliably negatively correlated: the bond portion would appreciate when equity markets fell, keeping the overall portfolio on an even keel.

In fact, the 60/40 portfolio was even better than that. Government bonds acted as an insurance policy, helping to cushion the investor against losses on their equity holdings, but this was an insurance policy the government paid you to own. The coupon on your bond holdings provided a material source of return, on top of the protection you gained by diversifying your equity risk.

Now that double benefit has turned into double jeopardy. As main central banks have lowered interest rates towards zero over the past decade, the yield component of the return on a portfolio of government bonds has evaporated. That leaves capital appreciation as the sole source of future returns. But the room for prices to rise has arguably all but disappeared too.

In the year to April 2020, the Barclays US Treasury Total Return Index gained nearly 9 per cent, as the US 10-year Treasury rate moved from 1.92 per cent to 0.64 per cent. This delivered a positive return that partially offset losses from falling equity markets. But if we are faced with another crisis, then US Treasuries simply cannot gain enough from here to offset equity losses. Why? Because the 10-year note has less than 0.9 per cent of yield left until it goes to zero — and the Federal Reserve and Treasury have made clear they are extremely reluctant to see negative interest rates.

This is why retail and institutional investors alike are now at a turning point. For investors who hold the classic 60/40 portfolio, this is a disaster. They have lost a reliable source of return and their diversification strategy is broken.

Imagine that you are just setting up your first retirement account to begin saving for your future. A traditional 60/40 blend would not deliver anywhere near the diversification or returns that it has done historically, therefore forcing you to own a portfolio dramatically skewed towards stocks.

Over the past three decades, a typical 60/40 portfolio has returned nearly 10 per cent on the equity portion per year and just under 6 per cent from the Treasury bonds, netting out at around 8 per cent a year overall. But with bonds at zero, investors will need much higher returns on their equity portfolios to maintain that record: around 13.3 per cent a year, in fact. This will inevitably encourage greater risk taking, with the potential for larger losses.

Advocating a portfolio like this with no risk-balancing is unfair and irresponsible. Doing so leaves these retirement savers totally reliant on continuing appreciation in stocks — and seriously exposed to downturns.

In seeking new sources of ballast for balanced portfolios, asset allocators will have to think about alternatives to bonds, including cash, gold, cryptocurrencies, and explicit volatility strategies — such as put options directly hedging equities — with which they may be less familiar. There are pros and cons to each selection, but the key point is that, with the diversifying power of bonds gone, there is no longer any natural choice.

That inevitably means we should expect lower returns in the future from balanced portfolios because “free insurance” through the bond market is no longer available. Paying for protection is never an appealing prospect. But now that investors are dangerously exposed to equity risk, it is one they and their advisers should at least consider.

Financial Times Opinion by Paul Britton

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