October 14, 2021 – In the 1990’s, the default investor portfolio included a significant allocation to a star fund manager’s equity mutual funds.
The typical investor portfolio included allocations to Fidelity’s Magellan Fund and Vanguard’s Windsor Fund.
Asset allocation has changed dramatically since the heyday of the star stock picker.
Mutual funds have become a sunset industry, commencing a long-term, terminal decline starting in 2015. As a result, active equity mutual funds appear to be going the way of the dodo bird.
In their wake has risen the ETF. Fund flows indicate that investors favour equity ETFs over mutual funds. These ETF inflows are not only for index-based strategies but also entail actively managed ETFs.
Source: Investment Company Institute; Bloomberg Intelligence
Over time, the default investor portfolio has transitioned from star fund manager’s equity mutual funds to a portfolio of 60% stocks (primarily through ETFs) and 40% bonds.
The 40% bond allocation was historically weighted to nearly half of an investor’s portfolio given the income generation potential of fixed income assets. For example, fifteen years ago, U.S. Treasurys yielded more than 5%. Back then, if an investor added corporate bonds to the mix, a 7-8% annualized return was possible through owning bonds. Thus, historically, the 40% bond allocation was a key driver and diversifier of 60/40 portfolio returns.
Now, with the U.S. 10-Year Treasury bond yielding less than 1.6% and investment-grade corporate bonds yielding 2.5%, the expected 2% return provided by bonds is likely insufficient for most investors to justify a fixed income allocation, especially with inflation running hot at 5%.
As interest rates have fallen, the justification for owning bonds has evolved. Throughout much of the past century, bonds were held to provide yield to an investor’s portfolio. However, with bond yields consistently below the inflation rate, the rationalization for owning bonds has changed to “portfolio protection”.
The Great Misconception
The concept of bonds as a diversifier and portfolio protector has relied on one key misconception: bonds move opposite of stocks in volatile markets.
Specifically, the relationship between stock returns and bond returns is highly volatile. The notion that the two asset classes are negatively correlated (move opposite of each other) is not supported by historical data.
As seen in the graph below, there isn’t much rhyme or reason to the relationship between stocks’ monthly returns and bonds’ monthly performance. Sometimes both go up, sometimes both go down. And sometimes, stocks and bonds move in opposite directions.
Source: Verdad Advisers, LP
Over the past decade, the correlation between stocks and bonds has averaged near zero, although with a fair amount of volatility.
As stock-bond correlation has swung between 0.5 (move in the same direction) and -0.5 (move in the opposite direction), the one conclusion that we can definitively deduce is that the relationship between stock and bond performance is too unstable to rely on for risk management.
Nonetheless, the low long-term correlation between stocks and bonds indicates that bonds provide a diversification benefit for investment portfolios. However, with inflation-adjusted returns on bonds expected to be negative, this diversification benefit does not provide reasonable justification for a significant allocation to bonds within an asset allocation framework.
Source: Bloomberg, Connected Wealth
The expected return is only one of three main characteristics an investor should consider in making asset allocation decisions (with the other two being risk and correlation). Bonds pass the risk and correlation tests but fail the expected return hurdle for a large allocation within a portfolio.
The cold, hard truth of this realization came to fruition in September. As stock investors witnessed the largest decline since the bear market of March 2020, their bond portfolios were of no help. Last month, bonds fell in tandem with stocks, resulting in a -3.5% decline for the 60/40 portfolio.
Did September returns finally represent the nail in the coffin of the 60/40 portfolio? Time will tell. What we do know is that September proved that relying solely on bonds for risk management and diversification is a bad bet.
Source: Financial Times
The Are Alternatives
Thankfully, innovation in capital markets has led to the proliferation of alternative investments. Specifically, alternative investments now live in low-cost alternative ETFs that are accessible to all investors.
Alternative investments can provide many benefits for investors, depending on the investment strategy, with the most significant being diversification.
As they say, the proof is in the pudding. Many alternative strategies highlighted their value-add to portfolios with positive performance in September, as traditional asset classes (stocks and bonds) both fell. While alternative investments are no panacea, and a one-month time frame is a small data point, September’s performance does reiterate the diversification benefit of alternative investments.
It is often cited that “diversification is the only free lunch in investing.” With alternative investments now arguably providing better diversification than bonds, who wouldn’t want a free lunch?
Accelerate manages five alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate OneChoice Alternative Portfolio ETF (TSX; ONEC): Alternatives portfolio solution
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Buffered index
- Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
A level of optimism is returning to the SPAC market after a 7-month bear market.
Positive price performance was driven by SPAC arbitrage yields declining, falling from 2.1% to 1.8% over the month. We are seeing new investors enter the SPAC arbitrage space – specifically fixed income investors, given a portfolio manager can generate higher yields from SPACs than corporate bonds while taking less risk. We expect this theme to continue as fixed income PMs will increasingly need to be creative to generate returns above inflation while keeping duration low.
In addition, for the first time this year, the upside optionality of a SPAC was on display as an issue traded from a persistent NAV discount to a NAV premium upon deal announcement. Nonetheless, one data point does not make a trend and SPAC arbitrage returns will continue to come from the amortization of discounts along with the monetization of warrants. High volatility around the deSPAC process has provided and opportune time to monetize SPAC warrants (obtained free through units) for maximal risk-adjusted return.
Merger arbitrage yields remain wide given concerns regarding the regulatory environment. Thus far, those concerns have not come to fruition. Nevertheless, risks are elevated but investors are being compensated in the form of historically high arbitrage spreads.
HDGE’s historical slight negative correlation has paid off as it attained a 2.4% return in September as equity markets rolled over.Long-short factors have continued their recent streak of positive performance, with the U.S. long-short multifactor producing positive monthly returns. While the U.S. long multifactor portfolio dropped -2.2%, the short portfolio declined -5.5%. HDGE’s long portfolios fell, although outperformed the market, while its shorts underperformed.
In September, the S&P 500 suffered its worst decline since its double-digit drop in March of 2020. It is notable that in both of these months, HDGE produced positive performance, supporting its goal of acting as a portfolio hedge.
Positive contributors for ONEC included long-short equity’s 2.4% gain, alternative equity’s 1.1% return, arbitrage’s 0.9% uptick and a 0.7% positive contribution from the leveraged loan portfolio.
ONEC detractors included bitcoin with a -8.3% return, real estate dropping -6.0%, gold off -4.0%, infrastructure down -3.5% and risk parity declining -3.1%.
Canadian factor performance was rockin’ in September. All five long-short factors contributed to positive ATSX overlay portfolio performance during the month.
The Canadian long-short price momentum portfolio led the pack with a 17.2% gain, as the long momentum portfolio rallied 8.4% while the short momentum portfolio declined -8.8%. The long-short trend portfolio also has a double-digit return, gaining 13.4%. All other Canadian long-short portfolio had positive performance for the month, with operating momentum gaining 4.4%, value returning 4.0% and quality up 2.9%.
It is in declining markets that ATSX’s long-short overlay portfolio usually shines. This downside protection of the overlay portfolio was on display in September, as the overlay portfolio generated a 3.1% gain while the TSX 60 declined -2.0%, resulting in a 1.1% return for ATSX.
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Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.