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For the past few years, we have been living in strange economic times. Signals that used to be solid indicators no longer correlate; even with strong inflation, consumer spending is strong; even with fears of recession, unemployment is historically low.
But one of the biggest breakdowns was in the relationship between stocks and bonds. Stock prices and bond prices are usually not correlated, meaning bonds can serve as the cornerstone of a hedge when stock prices waver and drop.
For most of the past two decades, that has been true.
In the past year, though, we have seen stock and bond prices move in a correlated manner. When both are rising, no one complains – but now that markets are seesawing, many investors are seeing, in alarm, that tandem rises are paired with tandem falls. If both asset classes move in the same direction, what risk management do bonds offer?
Stock-to-bond ratios are presented as the key indicator of how much risk is inherent in a portfolio: 80/20, 70/30, 60/40 – that’s all some people know about their holdings. When that ratio becomes less relevant, what’s an investor to do?
Normally capital markets are more chaotic, with less leadership, and shifting allegiances. The twin trends of large-cap U.S. leadership and low interest rates have left the building, and we won’t be returning to that environment anytime soon.
Positioning is more complex, as a more unsettled situation becomes the norm. The elements of risk management and alpha capture are more valuable ideals today than any time over the past 10 years.
Thinking creatively and getting granular
There is a better way to manage risk and seek out the best possible returns. It hinges on – get this – finding the best security selectors and understanding what is correlated at a given time.
The stock-to-bond relationship became hard-wired in people’s brains because we’ve had decades in which they moved in opposite directions. This isn’t an ironclad rule. If you look back over 60 years, stocks and bonds have been correlated more often than not, and there is not yet any reason to believe they won’t remain so most of the time.1
This excessive reliance on the expected relative performance of certain asset classes isn’t limited to bonds. Among equities, there is an expectation that U.S. large-cap stocks perform one way, and international equities another. However, U.S. stocks and international stocks have become highly correlated, particularly when asset prices are declining. Yet, many asset managers still simply fill these “style boxes” in a pre-set allocation with the right asset type, and voila – you have a growth or a conservative strategy.
Again, however, the data shows that some other force is at play. If you compare the return on the best and worst U.S. large-cap funds over the past 12 months as of June 30, 2022, the difference in the returns is approximately 50%.2 These are in the same asset class, so what accounts for the difference? It’s the equities that were chosen.
This might seem overly simple, but it comes down to who is picking which stocks and why. Different asset managers and different funds have different philosophies, different things they value. Because there are thousands of fund managers, each looking for their own angle, and because of the shift towards exchange-traded funds (ETFs), where investing tends to balance out good and bad picks, there has been less scrutiny placed on security selection. When everything is going up most of the time, why bother with security selection?
Putting in the work to be selective
Capital markets don't rise every year at an above-average rate. When capital markets are moving in a correlated fashion, security selection makes a difference. Under those conditions, investors benefit from risk management and the value added by security selection the most. Return and risk are not equal in their impact: Keeping up in good markets is a goal, but losing less in poor markets is far more beneficial to investors.
It's all about finding fund managers one trusts. That means not just looking at returns (which matter, of course) but also the philosophy and approach fund managers take, which takes time and attention. It also means looking for asset classes and/or strategies that are uncorrelated to equities to balance risk when other assets go down.
Look for firms that have filtered the many thousands of available funds to those few that they believe have brilliant managers. Furthermore, consider managed futures as an asset type that provides diversification to reduce risk. Some firms have a proprietary process to model different combinations of these select funds to create investment strategies that they believe will perform well compared to the market overall while providing a specific level of risk.
This doesn’t mean you should abandon diversification or lost faith in bonds; you can, but the funds you select should cover a very wide range of asset classes. When you look at strategies, look for a pie chart showing allocations that shift depending on the risk level desired. The difference is that the size of those pie pieces is determined by the combination of assets in the selected funds that our model shows will give us the best return for defined risk – not preset proportions that we fill in.
Geremy van Arkel, CFA, is director of strategies for Frontier Asset Management.
1Source: Frontier Asset Management. Stocks are represented by the Ibbotson® SBBI® US Large-Cap Stocks (Total Return) and Bonds are represented by Ibbotson® SBBI® US Long-term (20-Year) Government Bonds (Total Return).
2Source: Morningstar, Frontier Asset Management.
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