The advent of MPT brought a great deal of science and formal theory to portfolio construction.

Background

Since their inception, financial markets have provided investors with the opportunity to increase their wealth. However, this is of course not always the case – at times, and without warning, these markets see dramatic price declines or volatility, resulting in the significant decrease in investors’ wealth. These moves may be the result of a weakening economy, a systemic shock to a particular market, or the ending of a period of irrational enthusiasm by investors. Regardless of the driving force of these moves, investors must remain vigilant and well positioned to ensure that these periods of volatility do not cause permanent damage to their investment portfolio.

During the latter half of the 20^th century, significant advancements were made in the field of financial economics. These developments provide a superior framework for investors to manage and understand portfolio volatility and risks. One of the most significant developments was Harry Markowitz’s concept of Modern Portfolio Theory (MPT). A vital element of the theory was the formalising of an asset’s risk as the standard deviation of its returns, and in turn the formation of an efficient frontier of possible investments. This acknowledgement enabled investors to compare the risk-return profile of two assets and select the one with the highest return for a given risk, or the lowest risk for a targeted return. Another significant outcome of MPT was the recognition of how investors could achieve the optimal level of diversification within their portfolios.

While investors recognised the value of diversification prior to MPT, it was more of an art than a science, with successful portfolio managers relying on asset-picking and market timing. Both activities have proven all but impossible to implement successfully on a consistent basis across market cycles. Other investment strategies involved simple rules-of-thumb, such as 1/3 equities, 1/3 bonds and 1/3 real estate, or simply aiming to maximize returns.

Post MPT, new heuristics developed around the role of each asset class. Equities became known as the potentially higher returning assets, but with these returns came higher risk. Alternatively, the fixed income sector was seen as a source of lower but more stable returns. Therefore, an aggressive (conservative) investor would maintain a portfolio of 80% (60%) equities and 20% (40%) fixed income. Crucially, this high-level definition of fixed income investments did not discriminate between the various sub-classes within the fixed income universe. One class which is discussed later is credit assets.

The development of a formal asset pricing model was the next stage of evolution within the field of financial economics. The initial model, the Capital Asset Pricing Model (CAPM), divided risk into systemic risk (risk that cannot be avoided via diversification) and those risks particular to a given asset. From the CAPM came two significant metrics, the Sharpe ratio, and the information ratio (IR). The Sharpe ratio, developed by one of the originators of the CAPM model and Nobel Memorial Prize in Economic Sciences winner William Sharpe, became the accepted term for measuring risk-adjusted returns.

Equation 1 defines the Sharpe ratio, with:representing an assets or portfolio’s return minus the risk-free rate, defined as its excess return. To identify the excess return per unit of risk, the excess return is divided by the portfolio’s volatility, as measured by its standard deviation.

With the general acceptance of the Sharpe Ratio, the desire for additional metrics grew. One such example was the need for a metric to compare the variations of returns across, and within, asset classes.  The IR was adapted to assess these nuances. The key difference is that the risk-free rate is no longer included, replaced by the relevant benchmark for the portfolio. For instance, an Australian large cap manager would utilize the ASX200 as the benchmark, while a domestic credit manager may use a composite bond index.

While the Sharpe and Information Ratios have been widely adopted, they are not without fault. As seen in Equation 1, the denominator is the variance of a portfolio’s return, where these returns are assumed to be normally distributed. When returns display asymmetric results, the Sharpe ratio loses some of its relevance.

One point of difference between credit and equity securities is the risk of default. In this instance, default refers to an issuer of a given security not paying the legal coupon and/or returning the entire principal at maturity. In such an instance, the security is at a heightened risk of losing a considerable amount of its value. In comparison, a company is never obliged to continue dividend payments, nor to return any capital as shares exist in perpetuity. Therefore, a credit manager must manage market risk – that is the movement in credit spreads – and credit risk, which is the risk of default. In comparison, equity managers will look to manage the market risk of their securities as prices move in response to new public information.

Regarding the IR, the selection of a relevant benchmark is crucial. This choice is relatively straightforward for equity managers, but for fixed income managers the availability of an investable benchmark can be problematic. For example, a credit manager may invest across a broad range of securities, for example corporate bonds, private credit, structured assets, or distressed debt. All these assets have very different characteristics, meaning it is difficult to find a single relevant benchmark. Regardless of these issues, both ratios can make a meaningful contribution to the process of portfolio construction.

Australian case study

This section provides a brief practical example of how one might look to utilise MPT and associated metrics to construct an Australian domiciled investment portfolio. There will be a particular focus on the implications for assessing and selecting credit funds. The data also provided insights into the appropriateness of the two metrics across the various asset classes.

The figures and data used in this exercise are the 3 year (annualised) returns, associated standard deviation and relevant ratios sourced from the Morningstar Direct database for Australian diversified credit, and blended Australian mid/small and large capitalisation funds. Critically, this analysis is based solely on past returns and does not forecast future returns.

Figure 1 places the return profile of funds within the three fund categories in the classic risk/return space (returns on the Y-axis and risk/standard deviation on the X-axis). In general, the results are consistent with expectations that equity funds, on average, provide higher returns, but these come with greater risk (higher standard deviations). Additionally, within the equity space small/ mid-cap funds are riskier, with a large return variation within the peer group. Over the same period, credit funds delivered in general lower returns with lower risk, again consistent with the belief that credit funds will deliver relatively stable returns, at the cost of an uncapped upside.

Having identified an appropriate asset allocation, the next question is how to select the appropriate fund(s) for one’s portfolio. This analysis will mainly focus on the diversified credit segment. Prior to assessing the available credit funds, it is crucial to define the expectations around what one can expect from a credit fund. In general, a credit fund’s returns will predominately come from the yield of the securities within the portfolio. For an Australian fund, this yield will be greater than the official cash rate as set by the Reserve Bank of Australia (RBA).

The gap, known as the spread, primarily depends on the risk profile of the securities within a fund. The other source of return will be capital returns. This return fluctuates as the market price of credit securities fluctuates in a manner consistent with other risk assets. This capital return will also be affected if a particular security defaults or faces a ratings downgrade.

Returning to the expectations regarding a credit fund, it is most likely that investors will be after stable returns to offset the volatility stemming from the equity component of their portfolio. Therefore, the Sharpe ratio and IR are well placed to provide meaningful insights. From Figure 1, it is evident that there is a noticeable variation in risk and return for the 3-year numbers. Importantly, given the generally lower returns of credit funds, the effects of these variations become evident through an assessment of the Sharpe Ratios across the investment universe.

Figure 2 illustrates the variation in Sharpe Ratios across the three asset classes used in this paper. The first point that becomes apparent is that despite the variations in return and risk, the equity funds are quite tightly bunched. This position contrasts with the figures for the credit segment, where not only is there a broader spread but a noticeable proportion of the population returning a negative Sharpe ratio. The ramification of this characteristic is that managers were unable to outperform the cash rate, an outcome which is a red-flag when selecting any fund.

What are the implications of these findings? Credit funds offer compelling risk adjusted returns in comparison to equities. More importantly, the evidence suggests that investors need to carefully assess those funds to ensure they meet their investment objectives, which is primarily to provide a stable income flow with limited downside risk to the capital value of the investment.

What are the likely characteristics of a credit manager who can meet these requirements? At a minimum they are likely to be able to adjust the following attributes of their portfolio to meet the prevailing market conditions:

• Duration: A portfolio’s duration reflects how much the capital value of the portfolio will vary with a change in credit spreads. If spreads are expected to tighten (loosen) then a higher (lower) duration is appropriate. Therefore, a credit manager can underperform if they have extended their duration in the hope of improved market conditions, only for these conditions not to eventuate.
• Credit Risk: A credit manager can increase (decrease) their yield by going further down (up) the capital stack, as determined by a security’s credit rating. If a manager is anticipating benign conditions and increases their credit exposure, returns can be diminished because an issuer defaults on their payments or low rated securities de-rate further in a risk-off environment.

Figure 2 provides the data on the IR across the three selected asset classes. In contrast to the findings of assessing the Sharpe ratio, the results are far more informative for the equity funds than the credit funds. Informative in the sense that there is a greater variation in the results, which in turn enables investors to identify those funds which have outperformed on a risk adjusted basis. The data also provides an insight into the shortcomings of IR for assessing credit funds, that is the median IR is materially higher than those of the equity funds.

The origins of the contrasting IR results are seen in Equation 2. Utilising a benchmark as opposed to the risk-free rate allows one to identify the better performers within an asset class. This characteristic is particularly useful for equity funds where there is an obvious and, more importantly, investable benchmark. Indeed, from Figure 3 one can see that over 3 years the median large cap manager failed to better their benchmark, identifiable via a negative IR, indicating that an index fund may be a more appropriate investment. Alternatively, in the small/mid cap space the median manager has added value and there are several managers that have performed well.

Regarding the credit fund universe, there is not the dispersion of IRs within the sample. A partial explanation is that there simply is not the same quantum of opportunities to add (or destroy) excess value via a small number of positions that vary greatly from the benchmark – a common strategy for equity managers.  Compounding this point is the difficulty in establishing an effective benchmark because the credit markets are wide, with some sections lacking depth. However, the more relevant point relates to the purpose of a credit fund, which is to deliver lower but stable returns. Therefore, to identify the credit managers that have performed well the Sharpe ratio is more appropriate.

Conclusion

The advent of MPT brought a great deal of science and formal theory to portfolio construction. These developments allow investors to construct portfolios that meet their individual needs. However, there certainly is not a “one size fits all” approach, and it’s important to understand which ratio or approach is most appropriate for assessing their investment options. MPT has also allowed investors to clearly identify the role of each asset class within their portfolio and provides the ability to assess the risk-return characteristics of each class. As we’ve seen, credit funds were assessed as appropriate for investors seeking stable returns. This fact is not to say that excessive returns are not available in credit markets, rather to say that these sorts of returns are the exception. Another quandary for credit investors is to find an appropriate benchmark which offers a meaningful hurdle for managers to better. Therefore, assuming that past performance is no guarantee of future performance, the Sharpe ratio is the most appropriate way to compare the risk-adjusted returns of credit funds.

By Matthew Oldham, Head of Data Analytics and Chris Black, Co-Founder & Senior Portfolio Manager.

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The 60/40 portfolio does not always deliver positive returns for investors.

The end of a year is often cause for reflection. At the end of 2022, investors who took part in this process might have been left scratching their heads, and having thoughts like “What just happened?” or “That’s not how markets are supposed to work!” Additionally, a cursory glance into 2023 provides investors with perplexing choices as they consider the possible outcomes and strategies for the year.

To sum up 2022 in a few words, investors were caught in a dramatic regime shift. Central banks were forced to rapidly turn-off the flow of cheap and easy credit, and hike interest rates as inflation became “non-transitory.” This switch wreaked havoc with risk appetites and asset valuations. The following highlight some of the high-end casualties:

• The S&P 500 was down 19.4%, the seventhworst year in its history
• The Bloomberg Aggregate Bond Index (a broad-based fixed-income index used by bond traders and managers) had its worst year ever
• United States 10-year Treasuries had their worst ever year, and
• The third worst year ever for the standardized 60/40 (60% equities and 40% fixed income securities) portfolio

The last point is likely to have raised major concerns for conservative investors on two fronts. The first is that with equity valuations looking stretched going into 2022, investors would have felt confident that a sizable allocation to fixed income products would provide sufficient safety and insulation from falling share prices. History now shows that this was not to be the case. The second issue is that if that strategy did not work, for the reasons outlined below, how should they position themselves for the year ahead, especially considering that 2023 promises to be no less troublesome given serious geopolitical and macroeconomic concerns remain at the forefront?

Why would investors have been comfortable thinking that a 60/40 portfolio would provide sufficient protection in the face of any stock market correction? The theory behind the strategy is the assumption that bond and equity returns are negatively correlated. In practice, this relationship means that when the environment is right for strong equity returns (typically a strongly growing economy), interest rates will generally increase. Due to the inverse relationship between bond prices and interest rates (yield) this situation generally results in lower returns for bonds. However, the inverse is also assumed to be true in that an environment of falling growth will result in lower equity returns that are mitigated by the positive capital effect of falling interest rates on bond prices (as central bank lower interest rates to stimulate a stuttering economy). However, 2022 saw both equities fall, and rates rise, as central banks were forced to respond to inflationary concerns by raising rates.

Indeed, the 60/40 strategy had worked very well for investors since the 1980s. However, investors may have become complacent and were unaware that the strategy’s success had several tailwinds, many of which abruptly stopped in the second half of 2022. Furthermore, some of the crucial tailwinds are unlikely to reappear in the short-to medium term. One such factor is the direction and magnitude of interest rate changes.

To cure the excessive inflation of the 1970s, interest rates worldwide started the 1980s in the high teens. Once inflation was brought under control in the early 1980s, the bond market went into a structural bull market that lasted for 40 years. This is because, for the past 3 decades, central banks have been able to keep lowering interest rates whenever the economy was weakened. Central banks were able do this as the developed world remained in a disinflationary environment due to several factors, including globalization and step changes in productivity driven by technology. The disinflationary environment ended in 2022 in the face of rising structural inflation. The vital takeaway from this situation is that for the first time in 40 years, investors faced material interest rate risk – the risk of price fluctuations in fixed coupon bonds due to changing interest rates.

The failure of the 60/40 portfolio in 2022 was a direct result of the returns of bonds and equities becoming positively correlated. Promoters of the 60/40 portfolio would suggest that this outcome was a low probability event, a view supported by recent history. However, per Figure 2, faith in the negative correlation between equity and bond returns was misplaced as the last 20 years were an exception to the rule. In fact, there have been only three periods, with the two previous being short-lived, where the relationship has been negative.

Research into the equity and bond correlation (see articles from AQR^[1] and Schroders^[2]) highlights the relationship is not stable and is highly dependent on the regime in which markets find themselves. The upshot of the various research pieces suggests that the level of economic growth, the level and direction of inflation, and market volatility are the chief characteristics in determining the market regime.  Therefore, investors need to take particular care in assessing these variables going forward.

Investors faced an environment of low inflation and moderate economic growth until the middle of 2022, meaning that the negative correlation between bond and equity returns held true. However, once inflation gained a stubborn foothold and economic growth remained high because of post-COVID stimulus, the market switched to a regime where the more traditional positive correlation would rule. That is, interest rates were rapidly lifted by central banks off their all-time lows, with the duration effect (raising rates leading to lower bond prices) swamping the benefits of rising yields. This change coincided with equities coming off their post-pandemic peaks due to higher discount rates and emerging earnings uncertainties.

Importantly, it was not all doom and gloom in the fixed income markets. Fixed income is a broad term that encompasses a range of strategies, including those that avoid interest rate risk in their portfolios by investing in floating rate securities. The floating rate world is typically defined as “credit” as opposed to the fixed rate world of government bond investing. Credit managers are thereby a subset of fixed income managers who specialize in producing portfolios containing securities with little or no interest rate risk while managing an appropriate level of credit risk.

Interest rate risk disappears because the value of a floating rate security is not directly affected by changing interest rates. However, floating rate securities are not risk-free, rather the investors face credit risk, that is the risk that the issuer will be unable to make ongoing coupon payments or return the face value of the bond at maturity. Investors also have to consider spread risk, which is the risk that the market decides to increase or decrease the spread it charges over government bonds for different levels of credit risk.

Figure 3 provides an illustration of the both the pain and volatility that fixed rate bond holders (Aust. Govt Bonds) and equity holders (ASX200 Total Return) experienced compared to floating rate holders in 2022. As can be seen, a portfolio with a significant allocation to floating-rate assets would have offered the greatest level of stability in 2022.

In addition to nullifying interest rate risk, credit manager can adjust the exposure of the portfolio to changes in market pricing (credit duration) and the credit quality of their portfolios to match future market conditions. Quality is adjusted by increasing, or decreasing, a fund’s exposure to higher or lower rated securities.

For instance, if economic conditions are expected to decrease – an environment where equities will be falling – a credit manager would increase their investment grade exposure (BBB and above) at the cost of their non-investment grade (lower than BBB). While this in turn will also impact yield – a higher rated product will pay a lower coupon due to the lower risk associated with holding it – it leaves the portfolio better placed to withstand a deterioration in market pricing.

The other opportunity credit managers have to de-risk their portfolio is to shorten the average maturity of assets in their portfolio (credit duration). This aim is achieved by investing in short-dated securities (6-12 months) over long-dated securities (3 plus years). The less time a security has till maturity, the less its price is impacted by changes in market pricing. Therefore, in an environment where the market appetite for risk is expected to deteriorate, a portfolio with a lower credit duration will provide a better outcome.

Of course, the preceding paragraphs were primarily written with the benefits of hindsight, a luxury that investors do not possess. So what are investors to do going forward? To quote Chief Investment Strategist for Tangent Capital Bob Rice, “the old 60/40 portfolio did the things that clients wanted, but those two asset classes alone cannot provide that anymore. It was convenient, it was easy, and it’s over.”

The first step is to assess what market regime is likely to dominate in the coming years. As explained earlier, this choice will great affect the equity-bond return correlation. At the time of writing the consensus view is that while inflation may decline, it will remain elevated and above central bank targets, with economic growth also slowing. These factors create an opportunity for the positive correlation between equities and bonds to remain intact. The persistency of a positive correlation then has implications for investors who are not quite prepared to abandon the 60/40 asset allocation framework.

If an investor does wish to maintain a healthy allocation to fixed income products to offset potential volatility within equities, they need to consider how they allocate between interest rate and credit risk exposure, as both can perform different roles within a portfolio’s strategic asset allocation. With a material rise in interest rates during 2022, government bond markets now offer some yield to help protect against further rises in interest rates and, as per Figure 4, the market is expecting a reduction in rate levels heading into 2024.  However, because there is still considerable uncertainty about whether central banks will be able to bring inflation back into their target range, the outlook for interest rate markets is still likely to be quite volatile.

The volatility of 2022 provided plenty of issues for investors to consider, including how to allocate within the fixed income market.  Through investing in floating rate fixed income assets, especially those with a low credit risk, you’re likely to achieve a favourable result in a rising rate environment. Crucially, exposure to floating rate securities will reward investors, yet not expose them to unnecessary volatility.

By Dr Matthew Oldham, Head of Data Analytics

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Notes:
[1] https://www.aqr.com/Insights/Research/Journal-Article/Stock-Bond-Correlations
[2] https://www.schroders.com/en/us/insights/equities/what-drives-the-equity-bond-correlation/

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