With yields near multi-decade lows, many investors have determined that the compensation for holding cash, U.S. Treasuries, developed-market sovereign bonds, and other traditional diversifiers simply isn’t adequate. Others have concluded that the low yields will provide insufficient cushion to mitigate price movements to the downside. In response, many of these investors have either pared back their cash and bond holdings, or meaningfully reduced the duration of their bond portfolios – only to see yields fall even lower.
In a recent PIMCO Featured Solutions paper titled “Portfolio Diversification: Tweaking the Recipe and Expanding the Menu,” authors Ashish Tiwari and James Moore suggest a different approach to diversification –a two-pronged strategy that combines getting the most “bang for the buck” from traditional diversifiers and considering non-traditional diversifiers with higher expected returns and/or the ability to provide significantly more downside mitigation.
Years of nearly rock-bottom interest rates combined with the Federal Reserve’s plan to potentially hike them in December make the idea of reducing duration sound appealing. After all, when rates rise, bond prices tend to fall, and longer-term bonds are typically more interest-rate sensitive than shorter-term bonds.
But Tiwari and Moore suggest that the Fed’s short-term interest rate hike may not have the expected effect on long-term rates, and that’s one reason why significantly reducing duration may not be a good idea. Over time, bond investors are compensated for being long duration, so long as yield curves are upward sloping, which is nearly always the case (except in the late stages of an economic expansion). For this reason, “a structurally lower duration position is not advisable for the multi-asset investor with a moderate to long horizon.”
While the authors don’t entirely object to reducing duration – so long as it’s done “cautiously” – they suggest potentially extending duration (“slightly”) along with credit risk as part of an “enhanced cash” strategy.
Beyond duration management, investors should look to alternative investments to broaden their menu of diversifiers. Tiwari and Moore principally discuss managed futures and “alternative risk premia” – preferably, multi-asset long/short strategies with low or negative correlation to traditional asset classes.
The authors look at the historical returns for five model portfolios:
- 60/40 (i.e., 60% stocks/ 40% bonds)
- Alternative Risk Premia Model
- 60/40 +10% Alternative Risk Premia Model
- 60/40 +20% Alternative Risk Premia Model
- 60/40 +30% Alternative Risk Premia Model
The “60/40” portfolio is based on the S&P 500 and the Barclays U.S. Aggregate Index.
The Alternative Risk Premia Model is based on a rules-based strategy designed to capture time-series momentum, value, carry, and volatility risk premia across a wide variety of asset classes, sized to maintain balanced risk.
For the 10-year period ending September 2015, The 60/40 portfolio returned an annualized 8.5%, while the Alternative Risk Premia Model returned 13.4%. Moreover, the Alternative Risk Premia Model had annualized volatility of 8.1%, while the 60/40’s volatility was 9.0%.
For the portfolios that combined Alternative Risk Premia with 60/40 stock-and-bond holdings, the annualized returns increased along with the allocation to alternatives, from 9.0% to 9.6% to 10.1%; while the annualized volatility fell, from 8.2% to 7.4% to 6.8%.
For investors looking for the “free lunch” of diversification, “the pickings on the traditional buffet have gotten slimmer.” The solution to rock-bottom yields, say Tiwari and Moore, is to “broaden the menu and tweak the recipe,” continuing the food metaphor. There are still attractive options for long-term, risk-conscious investors, in the authors’ view, so long as they are willing to “fight inertia and expand their horizons.”
For more information, download a pdf copy of the white paper.