Traditional multi-asset investment products have fallen out of favour since Covid and the end of the low-yield era after the Global Financial Crisis (GFC). The primary cause of this change in sentiment was the rising correlation between equities and fixed income, which reduced the diversification benefit of traditional multi-asset strategies. Fixed income has been the main beneficiary of the shift as yields have risen across the globe over the last decade.
The period since the GFC and the pandemic has seen heightened economic uncertainty and a wider dispersion of investment opportunities. This change is rendering the traditional 60/40 equity-fixed income asset allocation model less suitable and calls for a different investment philosophy. Instead of a static allocation with a limited set of asset classes, investors need to look to dynamic management of a true multi-asset portfolio.
What has changed?
The current investment landscape is dominated by increased uncertainty over economic policies and outcomes. After several decades of rising globalisation and economic integration amid a benign global inflation backdrop, the post-Covid world has been marked by
- The return of inflation
- Less synchronised economic cycles
- Megatrends such as the energy transition or the rise of artificial intelligence.
The most recent spike followed US President Donald Trump’s ‘Liberation Day’ tariff announcements (see Exhibit 1).
How can a dynamically managed multi-asset portfolio address this environment?
The two key advantages of dynamic multi-asset strategies are:
- Asset allocation flexibility to address changing correlation regimes
- A broad range of instruments allowing for targeted exposures and access to the best opportunities.
Asset allocation flexibility
Over the last 30 years, the correlation between equities and fixed income has switched between negative (diversifying) and positive (unhelpful), with the most recent trend starting to return to negative (see Exhibit 2). Whether the correlation is negative or positive appears to be a function of the level of inflation. When core consumer price (CPI) inflation is below 2.5%, the bond-equity correlation tends to be negative, whereas inflation above 2.5% typically sees a positive correlation.
Each correlation regime requires its own allocation approach:
- Negative correlations favour a more traditional 60/40 equity-bond portfolio; this worked well during the first 20 years of this century
- Positive and/or unstable correlations argue for lower allocations to equities and fixed income and higher allocations to asset classes such as short duration (i.e., ‘cash like’) instruments, commodities (energy, base and precious metals) or alternatives such as private assets. When the bond-equity correlation is positive, the diversifying property of the traditional 60/40 portfolio is much diminished and other asset classes can contribute materially to reducing the volatility of a multi-asset portfolio.
The next few quarters will likely feature an oscillation around 2.5% for US inflation. This implies considerable uncertainty over the bond-equity correlation regime and therefore favours a continued flexibility in allocating between asset classes.
Access to a broad spectrum of securities
Dynamically managed multi-asset strategies generally have access to a broader set of asset classes than most traditional benchmarked funds. Their universe usually includes equities, fixed income, commodities, real estate investment trusts (REITs), foreign exchange and sometimes private assets.
Managers are able to actively switch among them depending on valuations, market sentiment, as well as fundamental and policy backdrops.
The biggest benefit from investing in a multi-asset portfolio composed of individual securities (as opposed to a ‘fund of funds’ portfolio) is the ability to optimise the investment opportunities.
For example, if a portfolio manager anticipated good risk-adjusted returns in 5-10 year South African and Brazilian government bonds, a fund-of-funds manager could allocate only to an emerging market (EM) local debt exchange-traded fund or a mutual fund which replicates the entire EM debt universe. As a result, the exposure to the desired government bonds would likely be only about 20% of the allocation. By contrast, a portfolio manager who can make ‘direct line’ investments could purchase only the targeted securities (see Exhibit 3).
Conclusion
The increasing instability of the bond-equity correlation may necessitate a move away from pure strategic asset allocations, also known as benchmarked portfolios, to more dynamic multi-asset portfolios.
The latter can not only shift their allocations between asset classes (beta rotation), but also access idiosyncratic opportunities within each asset class (alpha generation).
Moreover, the ability to allocate to specific instruments within a benchmark (e.g., gold in a commodities basket) has the potential to generate above-average returns while avoiding exposure to less attractive parts of the benchmark.
