Historically, investors and portfolio managers ideally adjust to a 60/40 portfolio (60% stocks and equities, 40% bonds) that provides a balance between growth from stocks and stability from bonds. From 1905 through 2024, such strategy has compounded a 9% CAGR with annualized volatility. Which is why it is a popular strategy among investors to pursue it.
Recently, with the worsening debt markets, the debt dynamic is worsening around the world as the debt levels increasing, concerns are rising about the financial sustainability of the bond-stocks dynamic. Previously Central Banks supported the market by buying debt for quantitative easing. One of many reasons for this is to allow increasing money supply in the economy while decreasing the level of debt while maintaining financial stability (increasing liquidity for banks to lend, i.e. promoting lending activity). Another reason is also to lower interest rates, as QE injects new money into the banking system, increasing supply of reserves that commercial banks hold, where banks likely to lend money at lower IR when there is more reserves at the bank which will also cause assets to increase (stocks, real estate; a spillover effect that drives up their prices and pushes down their yields (IR)). Thus, historically stocks and bonds are negatively correlated.
Although QE has been the case for CB around the world to maintain the financial stability of markets, recently it has retracted such policies (temporarily). The term premium is the extra yield that investors require to hold longer-term bonds instead of rolling over short-term bonds. With central banks stepping back, the direction of the term premium is uncertain.
Real yields are now positive and the math of owning bonds is far better now than it was a few years ago. This makes bonds more attractive compares to the low or negative real yields in previous years. But since 2022 they have not provided the relative balance that the 60/40 paradigm had generally provided since the late 1990’s. Looking at the distribution of risk or annualized volatility and return, we see that a 60/40 index appears to have delivered through 1950 to 2024 with CAGR of 9% and 9% volatility as stated before which is great. But in recent years the correlation between the stocks have inverted with bonds are no longer a port in the storm, and even are now a viable competitive asset class.
Personally I do think this might be correlated to the increasing uncertainty of the current world market (leading to bonds to increase in value) but also having the AI momentum increasing do cause the stocks prices to rise. There are still a lot of uncertainty regarding recession and many are hoping for a soft landing of the world economy.
But given the changing dynamics in the financial markets, it’s worth considering other asset classes that might provide better risk-adjusted returns (Sharpe ratios) and diversification benefits. Alternatives (Alts) such as hedged equity, managed futures, commodities, and gold have historically shown the potential to deliver these benefits. Hedged equity strategies, which involve holding long positions in stocks while also taking short positions to hedge against market declines, can help mitigate downside risk while capturing upside potential. Managed futures, which take long and short positions in futures contracts across various asset classes (commodities, currencies, interest rates, equity indexes), offer diversification through exposure to different market trends. Commodities and gold, traditionally uncorrelated with equities and bonds, provide diversification benefits and act as a hedge against inflation and economic uncertainty.
Historically, from 1998 to 2020, the negative correlation between stocks and bonds allowed bonds to provide competitive returns, and modest volatility, and act as a stabilising force in portfolios. However, post-2020, this correlation has become positive, reducing bonds’ effectiveness as a diversification tool. In this new environment, alternatives may offer better diversification benefits. Evaluating these alternatives through Sharpe ratios reveals that they have historically delivered superior risk-adjusted returns compared to traditional asset classes. However, it is important to consider liquidity constraints, as alternatives are often less liquid than stocks and bonds, which could impact the portfolio.
In the new structural regime, bonds still play a role due to their positive real yields and improved return potential, but they may no longer serve as the primary diversification anchor. To achieve better diversification and potentially higher risk-adjusted returns, incorporating alternatives and commodities into the portfolio could be beneficial. These asset classes offer the possibility of uncorrelated returns and competitive performance characteristics, making them valuable additions to the traditional 60/40 portfolio.
In summary, while bonds have historically provided a balancing force in diversified portfolios, recent changes in market dynamics necessitate a fresh approach. By incorporating alternatives and commodities alongside traditional assets, investors can create a more resilient and diversified investment strategy that is better suited to the current environment.
