How diversification can help returns through all conditions

Ten-year gilt yields rose steadily in the first two months of 2018 to a high of more than 1.6% (figure 6). They fell back slightly from late February, but even at these levels UK government bonds are once again looking like a viable alternative to holding cash in portfolios.

We have long believed that with yields so low, gilts offered little advantage over cash for a typical diversified portfolio and were vulnerable to capital losses. 

But with 10-year gilt yields now at levels not seen since late 2016, the extra income compared with cash is starting to look reasonably attractive again. The downside for prices (which move inversely to yields) also looks more limited. 

Despite our expectation that inflation will fall slightly over the medium term, real returns from gilts (yield minus inflation) will probably still be negative. Yet the total return should be higher than the interest from holding cash. Even if yields rose by another 0.3 of a percentage point and prices fell accordingly, our models suggest 10-year gilts would still generate a positive absolute return for the year ahead (i.e. not lose money if we ignore inflation).

In addition, bond markets appear to have priced in two rate hikes before the end of 2018, and we see little risk that rates will go up more than that, pushing gilt prices lower.

Importantly, gilts can help to protect multi-asset portfolios against an economic shock, which could result from a rise in global protectionism or the increased chance of a hard Brexit that excludes any trade deal with the European Union. The time appears ripe to reintroduce an allocation to gilts now that this insurance policy is being offered at more attractive yields.

Figure 6: 10-year UK gilt yields

Yields have returned to levels where gilts can once again be considered a viable alternative to holding cash.

Source: Datastream and Rathbones.

Alternative strategies

In addition to having sufficient liquidity, we believe a sensibly diversified portfolio should include securities that we classify as ‘diversifiers’. As the name implies, we expect these diversifiers to add returns to portfolios that do not track, or are uncorrelated to, equities and bonds. We also expect them to generate a positive return over time, taking advantage of anomalies in the market that skilled managers can exploit. 

Here we look at some of types of diversifiers, their role in multi-asset portfolios and some of the conditions that might be conducive to positive performance. 

Long—short equity, where managers can make a profit when share prices rise and others fall, is one of the most popular diversifying strategies, though some funds in this category track equities fairly closely and we wouldn’t consider them as diversifiers. The average stock market correlations have fallen dramatically over the past 18 months, which in theory should create better conditions for identifying winners and losers. However, managers may not get their stock-picking right. 

Event-driven funds seek to exploit pricing inefficiencies that may occur before or after a corporate event, such as an earnings call, bankruptcy, merger, acquisition or spin-off. President Donald Trump’s tax reforms could create some interesting opportunities for US companies as they begin to repatriate their foreign earnings.

Yet deal risk continues to be an important issue for event-driven strategies. Many managers were affected when the US government challenged the proposed merger of AT&T and Time Warner. More recently, Mr Trump has prevented what would have been the biggest-ever tech deal by blocking Broadcom’s bid for Qualcomm, citing national security issues. Again, stock-picking is key to capturing returns from these anomalies.

Global macro managers invest according to economic and political conditions in various countries. Returns have been disappointing recently owing largely to the absence of volatility in currency markets. However, risks such as a hard Brexit, a global trade war, central banks raising rates too far or a divergence in interest rates between regions could create opportunities in the year ahead. However, these strategies may struggle in a scenario of continued synchronised global growth and low volatility.

Commodity trading advisers (CTAs) — also known as trend-following funds – use derivative contracts across all asset classes to generate returns from market trends. Performance from this group was particularly strong at the end of 2017 with managers able to capture gains from rising energy prices, rallying equities and significant currency moves. Short-term reversals in markets, such as the one experienced in February, can be difficult for CTAs.

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