Reflection Series - Inflation and your portfolio: Part III
Numerous economic indicators and heightened geopolitical risks point to increased market volatility and recession risks for the second half of 2022 and the year ahead. Investors are well advised to switch to an all-weather portfolio framework for smoother navigation through the vagaries of economic, business and asset cycles.
The all-weather or all-season portfolio concept is an asset allocation approach that aims to provide resilient and consistent performance in different market regimes. It suggests that there are four seasons in the financial world and that no one knows for sure which one will be next. These 4 economic environments will ultimately affect whether an asset’s price will increase or decrease. So the idea is to construct a balanced portfolio in such a way that it makes no predictions about what the future will bring. Instead, it seeks to generate stable real returns, regardless of the performance of the markets. The standard all-weather portfolio mandate consists of 55% bonds, 30% equities and 15% hard assets (gold + commodities), but it can deviate from this standard to increase the allocation to stocks and/or commodities, as would be recommended for an all-weather strategy in 2022. The approach can also be applied to a single-asset strategy.
The Basic of an All-Weather Portfolio
The all-weather portfolio framework assumes that there is an equal chance that one of the four market regimes (expansion/recession, growth/inflation) will prevail at any given time and two of these regimes may overlap. This approach has created and paved the way for what is known as "risk parity" in investment. By balancing risk equally across the four environments, one can achieve consistent risk premiums for selected asset classes while minimising the sensitivity of the portfolio to any one environment.
The table below illustrates how different macroeconomic environments (i.e. rising growth, falling growth, rising inflation and falling inflation) benefit different asset classes.
The idea is to exploit the structural diversification that arises from the fact that different types of assets react differently but logically to each of the different economic regimes, due to the price mechanics inherent in each asset. Risk parity implies that the risks of the portfolio are spread equally over the 4 economic seasons. In addition to the benefits of structural diversification across investment styles, this strategy keeps portfolio risk and volatility at a target level while exploiting opportunities
Understand risk and diversification
This is the fundamental element for understanding an all-weather portfolio. Stocks have market risk, debt has interest rate risk and commodities have price risk. The first step is to understand the risk profiles of each asset class and allocate accordingly. For example, the choice of investment-grade bonds and commodities will respond to an inflationary regime. Stock selection will prompt a series of reflections on the imminence of a recession and the anticipation not only of inflation but also of slowing growth and stagflation. The all-weather strategy has been designed to address these issues before they arise, taking full advantage of the powers of diversification.
Consider asset correlations
Asset correlations show the extent to which assets move with each other, both within an asset class and between asset classes. Bonds tend to give stable returns, even when the equity market is in sharp decline. Similarly, even within equities, defensive stocks do not move in tandem with high-beta stocks. Other asset classes, such as gold and other commodities, have a negative correlation with most other asset classes. The key to creating an all-weather portfolio is to combine assets that have low or even negative correlations.
Look at gold as a hedge
Another important step in creating an all-weather portfolio is to incorporate a hedging strategy, for example by allocating 10% to 15% to gold, also in the form of gold bonds or gold ETFs. The advantage of gold is that it outperforms in turbulent market conditions and is, therefore, a natural hedge against negative returns from other asset classes. In addition, gold is historically uncorrelated to equities, making it a real advantage for creating an all-weather portfolio.
Take a serious look at commodities
In general, industrial commodities follow a much longer and more predictable up and down cycle. By including commodities, it is, therefore, possible to take advantage of the upward trend, and spread the risk of the portfolio. The allocation can be made either through equities, funds or commodity ETFs.
Consider a phased approach to investing
It is one of the best ways to create a versatile portfolio. By taking a phased approach to investing, the average cost method automatically works in favour of risk and the average cost reduction. This method is useful in all types of market conditions, from falling markets to volatile markets. It allows investors to invest regularly with a smaller amount of money and still enjoy the long-term benefits of the Dollar Cost Averaging (DCA) method.
Balanced funds as a good substitute
Balanced funds mix debt and equity securities to provide a combination of wealth creation and stable income, which automatically makes them "all-weather" investments. Even within the balanced fund category, there are options that make them more or less flexible. Some balanced funds are predominantly equity and others predominantly debt. These two extremes can be effectively combined with a dynamic investment plan that automatically changes the equity/debt mix according to market conditions. This is another very good approach to building an all-weather portfolio.
There are two key ingredients to creating an all-weather portfolio. The first ingredient is risk parity, which allocates assets so that each asset contributes equally to the overall risk of the portfolio. Secondly, once the risk parity weights are defined, the all-weather portfolio incorporates a certain level of volatility accordingly. In practice, an all-weather portfolio can also be implemented using futures contracts, as they are highly liquid and resilient to financial shocks. Historically, futures markets have shown strong resilience when financial market liquidity dries up. Thus, the all-weather portfolio that makes use of futures will be less constrained by liquidity considerations.
Disclaimer: This article is provided for information purposes only and does not constitute an invitation to invest. Please seek advice from your investment advisor before investing.