It has long been established that the most effective way of managing investment risk in any kind of portfolio is to diversify assets. Diversification has been the subject of many studies over the decades, and to this day, this fundamental concept cannot be emphasised enough when it comes to portfolio construction, especially when investment advisors continue to be met with poorly diversified portfolios, or even worse, large single asset concentrations. Mixing bonds with equities should serve as a good starting point.
In practice, portfolio diversification is measured through what is known as the correlation coefficient, a statistical measure of significant importance, but perhaps one that is typically overlooked throughout the portfolio management process. Correlation is a measure of the tendency for two assets or asset types to act in similar ways.
In other words, two assets whose returns move perfectly together 100 per cent of the time will have a correlation of +1, whereas, assets that are distinguished from each other, such that the return from one asset provides no prediction on the movement of the second asset, will have a correlation of -1. Buying assets that are less than perfectly correlated with one another, should prove to be beneficial in terms of risk reduction.
History is by no means an indicator of what is yet to come, but it still serves a very solid purpose by suggesting that bonds and equities have exhibited favourable correlations over longer periods of time. Both assets offer an attractive opportunity for portfolio diversification when combined, and therefore, investors who expose themselves to a certain degree of equity risk to an existing bond portfolio, are already better positioned in terms of portfolio risk vis-à-vis a portfolio that is purely focused on bond instruments, or vice versa.
But assuming that asset classes exhibit constant or static correlations that do not change over time, is undoubtedly one of the biggest misconceptions. In reality, correlations between asset classes are affected by a number of macro-economic variables, with interest-rate uncertainty being one of them.
According to data compiled by Morningstar, an investment research company, the correlation between equities and bonds stood at 0.10, on average, since the early 1960s. However, larger fluctuations can be seen over shorter periods of time, with some of the most significant upswings being recorded during 2022. Recall that, during this time, developed economies where characterised by a heightened level of uncertainty caused by a combination of unforeseen factors.
In February 2022, Russia invaded Ukraine and prompted a major escalation of tensions between the two nations in a war that had commenced back in 2014. This, in turn, caused severe supply-side shocks that resulted in soaring inflation numbers. Not to mention that, at the time, the effects of the COVID-19 pandemic were still being felt in some way or form. Ultimately, major central banks had to respond to the threat of spiking inflation through tighter monetary policies.
Bonds and equities both posted negative returns in what had been a very unusual year, as the correlation between the two increased drastically, providing little to no diversification benefits to unhedged portfolios. Looking back, typically, asset correlations tend to converge when market volatility increases, and what has been a properly diversified portfolio once, may be less so during such periods.
Bonds and equity instruments are just the tip of the iceberg, and investors who want to be even more effective in reducing risk through diversification can consider other asset classes, such as commodities, a broadly distinct asset class with returns that are independent from those earned from equity and fixed-income markets.
The portfolio management process should be regarded as a continuous process, both through the eyes of an investment advisor, as well as through the eyes of the client. Regular analysis of asset correlations should be given the necessary considerations to ensure that portfolios continue to be adequately diversified, while also remaining aligned with the evolving nature of investment policy statements.
Finally, although the increased availability of low-cost trading platforms, including self-managed platforms, offer convenience and cheap trade execution, these profoundly lack the human interaction and expert advice element, which could prove to be useful for a more effective risk management framework.
Andrew Muscat is senior client manager at Curmi & Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments.
Curmi & Partners Ltd is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.