Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Negative correlation threatens flip
The negative correlation between bond and equity returns is taken as scripture in financial markets. But Capital Fund Management (CFM) warns that the times may be changing.
The negative correlation between bond and equity returns is the (relatively) simple idea that when equities go down, bonds go up, allowing bonds to act as a hedge for equity exposure. But the negative correlation is a “historical anomaly” that could easily flip and see bonds and equities moving in lockstep, according to research from Paris-based CFM.
“From the point of view of a traditional investor, the main consequences would be on the future performance of the 60:40 portfolio and an inability or difficulty in diversifying it,” says Philip Seager, head of quantitative investment solutions at CFM.
In a positive correlation world, fixed income instruments – the “holy grail” of defensives – would be unhelpful in the construction of a portfolio with similar characteristics to that of the traditional 60:40. Investors might instead use derivatives, including options to hedge against equity crashes, though the premium could make them unattractive for this role. CFM is stress testing its portfolios against a potential regime shift and trying to reduce its sensitivity to positions leveraging the correlation, while also investigating the ability of trend following strategies to generate positive returns – a continuation of the work it has been doing since its inception in 1991.
“We’re trying to build upon the knowledge that we have of trend following to enhance its defensive features and make it into a hedge strategy,” Seager says. “What we’ve found is that, as much as we have less defensiveness and hedge than you can get in options, you don’t get the same level of bleed.”
Macro investing is another potential port in the storm (though Seager notes that it is a more of a diversifier than a true hedge despite some financial commentators touting it as “the new fixed income”) and CFM has been attempting to “systematise” macro investing strategies to complement the work it is already doing around trend following.
“We try and get into the mind of an analyst or a discretionary macro trader and try and understand what the driving force is behind these typical macro strategies and see whether or not the effect is persistent or – in geek language – statistically significant, and then take those strategies that are statistically significant and put lots of them together,” Seager says.
“The advantage that we have – and this is kind of a sign of the times, not just in finance and investment but elsewhere in society – is that with the sheer volume of data that one has access to these days, an algorithmic, systematic approach has much more potential to extract information from the market… There is tremendous capacity and potential for analysis of very large data sets in adopting this approach, and so we’re systematising this macro approach and looking more closely at that as a diversifier for portfolios.”
While the negative correlation is essentially orthodoxy in financial markets, the actual reasons for its existence are poorly understood, although it seems that inflation expectations could be an important part of the puzzle. CFM notes that the correlation between bonds and equities was broadly positive for more than a century prior to 1997, when a “brutal” flip took place amidst the Asian financial crisis and inflation expectations sinking to below 3 per cent.
“It’s difficult to have a prior belief on whether the correlation between bonds and equities should be positive or negative, but we believe there is actually a behavioural shift through that period of time in 1997-1998 where market participants became more confident in the central banks’ ability to control and tame inflation,” Seager said.
The co-movement of equity and sovereign bond markets during the volatility of early 2020 reignited the debate about the permanency of the negative correlation, and rising inflation expectations have fuelled it further. Unlike previous financial crises, stimulus has made its way into the real economy through fiscal measures designed to increase consumer spending. While this could result in the transitory inflation that many are already predicting, CFM notes that a range of factors – including a worrying trend towards de-globalisation creating work shortages – could combine to make this temporary spike in inflation more permanent.
If investors were no longer convinced that central banks could control inflation – or that they were even interested in doing so – then the correlation could flip. In some areas, CFM believes it already has.
“Let’s be clear: the correlation looks like it’s flipped in the US and looks like it’s getting close to that elsewhere,” Seager says. “In Europe it’s running at a correlation close to zero… Of course it could go back, and we’re not forecasting where that correlation is going to be. But what we’re saying is, be aware of the fact that this correlation can change and account for it in how you build portfolios.”
