Those saving for retirement face the reality that fixed income may no longer serve as an effective portfolio diversifier and source of meaningful returns.
In future fixed income is unlikely to provide the same level of offset in a portfolio as has transpired historically when the inevitable sharp decline in sharemarkets occur – which tend to happen more often than anticipated.
The expected reduced diversification benefit of fixed income is a growing view among many investment professionals. In addition, forecast returns from fixed income, and cash, are extremely low. Both are likely to deliver returns around, if not below, the rate of inflation over the next 5 – 10 years.
Notwithstanding this, there is still a role for fixed income within a portfolio.
However, there is still a very important portfolio construction issue to address. It is a major challenge for retirement savings portfolios, particularly those portfolios with high allocations to cash and fixed income.
In effect, this challenge is about exploring alternatives to traditional portfolio diversification, as expressed by the Balanced Portfolio of 60% Equities / 40% Fixed Income. I have covered this issue in previous Posts, here and here.
Outdated Investment Strategy
There are many ways to approach the current challenge, which investment committees, Trustees, and Plan Sponsors world-wide must surely be considering, at the very least analysing and reviewing, and hopefully addressing.
One way to approach this issue, and the focus of this Post, is Tail Risk Hedging. (I comment on other approaches below.)
The article is written by Ron Lagnado, who is a director at Universa Investments. Universa Investments is an investment management firm that specialises in risk mitigation e.g. tail risk hedging.
The article makes several interesting observations and lays out the case for Tail Risk Hedging in the context of the underfunding of US Pension Plans. Albeit, there are other situations in which the consideration of Tail Risk Hedging would also be applicable.
The framework for Equity Tail Risk Hedging, recognises “that management of portfolio risk and equity tail risk, in particular, was the key driver of long-term compound returns.”
By way of positioning, the article argues that a reduction in Portfolio volatility leads to better investment outcomes overtime, as measured by the Compound Annual Growth Return (CAGR). There is validity to this argument, the reduction in portfolio volatility is paramount to successful investment outcomes over the longer-term.
The traditional Balance Portfolio, 60/40 mix of equities and fixed income, is supposed to mitigate the effects of extreme market volatility and deliver on return expectations.
Nevertheless, it is argued in the article that the Balanced Portfolio “limits portfolio volatility in benign market environments over the short term while making huge sacrifices in long-run performance.”
In other words, “It offers scant protection against tail risk and, at the same time, achieves an under-allocation to riskier assets with higher returns in long periods of economic expansion, such as the past decade.”
The article provides some evidence of this, highlighting that “large allocation to bonds still failed to provide enough protection to add value over the cycle — reducing the CAGR by 170 basis points.”
Essentially, the argument is made that the Balanced Portfolio has not delivered on its promise historically and is an outdated strategy, particularly considering the current market environment and the outlook for investment returns.
Meeting the Challenge – Tail Risk Hedging
The article calls for the consideration of different approaches to the traditional Balance Portfolio. Naturally, they call for Tail Risk Hedging.
In effect, the strategy is to maintain a higher allocation to equities and to protect the risk of large losses through implementing a tail risk hedge (protection of large equity loses).
It is argued that this will result in a higher CAGR over the longer term given a higher allocation to equities and without the drag on performance from fixed income.
The Tail Risk Hedge strategy is implemented via an options strategy.
As they note, there is no free lunch with this strategy, an “options strategies trade small losses over extended periods when equities are rising for extremely large gains during the less frequent but devastating drawdowns.”
This is the inverse to some investment strategies, which provide incremental gains over extended periods and then short sharp losses. There is indeed no free lunch.
The article concludes, “diversification for its own sake is not a strategy for success.”
I would have to disagree. True portfolio diversification is the closest thing to a free lunch in Portfolio Management.
However, this does not discount the use of Tail Risk Hedging.
The implementation of any investment strategy needs to be consistent with client’s investment philosophy, objectives, fee budgets, ability to implement, and risk appetite, including the level of comfort with strategies employed.
Broad portfolio diversification versus Tail Risk Hedging has been an area of hot debate recently. It is good to take in and consider a wide range of views.
The debate between providing portfolio protection (Tail Risk Hedging vs greater Portfolio Diversification) hit colossal proportions earlier in the year with a twitter spat between Nassim Nicholas Taleb, author of Black Swan and involved in Universa Investments, and Cliff Asness, a pioneer in quant investing and founder of AQR.
I provide a summary of their contrasting perspectives to portfolio protection as outlined in a Bloomberg article in this Post. There are certainly some important learnings and insights in contrasting their different approaches.
The Post also covered a PIMCO article, Hedging for Different Market Environments.
A key point from the PIMCO article is that not one strategy can be effective in all market environments. This is an important observation.
Therefore, maintaining an array of diversification strategies is preferred, PIMCO suggest “investors should diversify their diversifiers”.
They provide the following Table, which outlines an array of “Portfolio Protection” strategies.
In Short, and in general, Asness is supportive of correlation based like hedging strategies (Trend and Alternative Risk Premia) and Taleb the Direct Hedging approach.
From the Table above we can see in what type of market environment each “hedging” strategy is Most Effective and Least Effective.
For balance, more on the AQR perspective can be found here.
You could say I have a foot in both camps and are pleased I do not have a twitter account, as I would likely be in the firing line from both Asness and Taleb!
I think we can all agree that fixed income is going to be less of a portfolio diversifier in future and produce lower returns in the future relative to the last 10-20 years.
This is an investment portfolio challenge that must be addressed.
We should also agree that avoiding large market losses is vital in accumulating wealth and reaching your investment objectives, whether that is attaining a desired standard of living in retirement, ongoing and uninterrupted endowment, or meeting future Pension liabilities.
In my mind, staying still is not going to work over the next 5-10 years and the issues raised by the Institutional Investor.com article do need to be addressed. The path taken is likely to be determined by individual circumstances.
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