Getting the most from a Balanced portfolio in market turmoil

While stress in financial markets can be worrying, it is important to focus on your long-term investment strategy, says Lonsec.

The challenges of owning a “balanced” portfolio consisting of equities and bonds is front of mind given the broad market volatility that has occurred in 2022.

The so-called death of the 60/40 portfolio has been raised many times following the global financial crisis. That being said, this portfolio has performed exceptionally well over this period.

The average calendar year return from 2009 to 2021 has been 9.3 per cent, with those adopting a buy and hold, static approach to portfolio construction having generally been well rewarded.

That has all changed this year. “Balanced” portfolio returns have been challenged by the war in Ukraine and central banks that have pivoted more quickly than expected to raising interest rates in response to inflation.

For the calendar year until the end of May, the “balanced” portfolio is down 7.1 per cent, which is the worst start to a calendar year in the last 20 years. What is different in the 2022 sell-off is the performance of bonds and the breakdown in diversification benefits that bonds typically offer to a balanced portfolio.

While the negative correlation between equities and bonds is often written about as if a universal law of investing, the correlations between the two asset classes certainly aren’t static through time and can be highly sensitive to changes in market conditions and regimes.

Rolling one-year correlations have been quite volatile over the last 20 years. A more medium-term representation, as shown by the rolling three-year correlation, shows that the two asset classes were generally negatively correlated in the period from 2002 to 2012, but turned more positive in the last several years and spiked early in 2022.

The takeaway from this is that positive correlations between equities and bonds are not necessarily anything new, rather the correlations are time varying in nature. Of course, a positive correlation between the two is less acceptable when markets are falling as they have been this year.

So, what does the future hold?

Regime change, a term used to describe a structural shift in the economic environment, has become the topic de jour.

For much of the last 20-30 years, the environment has been dominated by low inflation (and falling interest rates) and moderate growth, which, is favourable for both equities and bonds. Importantly, bonds have been a great diversifier while delivering positive returns.

Conversely the current backdrop of higher inflation, rising interest rates and low growth is less favourable for equities and bonds.

The duration and persistency of these regime changes is never certain, however markets can be fast moving and naturally reset themselves after periods of extreme market performance.

Ten- year bond yields in the US and Australia have already priced in a number of rate rises and some multi-asset managers, after a period of little exposure to bonds, are now talking about them offering better value in some circumstances.

While stress in financial markets can be worrying, it is important to focus on your long-term investment strategy and ensure portfolio asset allocations are aligned with your goals and objectives. Return outcomes over shorter term time horizons can be wide, however the range of potential outcomes tends to narrow over longer-term time horizons.

Over the past 20 years, returns over rolling 10-year periods have ranged from 5.3 per cent to 7.6 per cent per annum.

The 5.3 per cent per annum return was for the 10-year period ending December 2011 and included the drawdowns of 2002 and 2008, highlighting that staying the course can be a valuable strategy in itself when correctly aligned to your risk profile and overall objectives.

The multi-asset universe is exceptionally broad consisting of static asset allocation approaches to those taking active asset allocation and/or active security selection decisions.

If the forward-looking environment continues to be challenged, multi-asset managers will have to lean on these asset allocation and security selection levers to enhance the risk and return profile of their portfolios.

Many multi-asset funds have the flexibility in their mandates to tilt portfolios away from their reference asset class benchmark, in addition to introducing other asset classes within their portfolios to support diversification benefits.

Funds with greater asset allocation tools can be useful for investors who require greater certainty in outcomes, are close to or in retirement, or have a specific goal suited to the fund in question.

Darrell Clark is the deputy head of research at Lonsec Research.