Works well but the downside needs to be managed
There is lots of client interest in alternative asset classes, mainly because bonds no longer provide enough income and because they are structurally vulnerable to inflation. This week, we demonstrate this it is possible to generate superior long-term returns by adding REITs to an actively managed portfolio of equities and bonds. The key messages are (1) that the combined portfolio needs to be actively and systematically traded and (2) that exposure to REITs must be properly constrained in order to avoid the savage drawdowns that are characteristic of this asset class. We also note that US REITs have performed very strongly this year, so now may not be the time to start this strategy.
Multi-asset diversification works, but hasn’t done so recently
Successful diversification using publicly-traded alternative asset classes, like commodities, REITs and TIPS is possible. We can select from a family of systematically-managed portfolios, which allow us to capture the upside of diversification and avoid most of the downside. However, the big takeaway from this process is that multi-asset diversification itself has been largely redundant since the end of the financial crisis, thanks to the actions of the Federal Reserve. Since that time there have been two false dawns, when it looked as though the concept was about to make a comeback and we may be on the verge of another one now. If it turns out to a real dawn, we have the regime management skills to exploit it. If not, we should be able to get out without too much harm.
We have a process. All we need is the upswing.
We know how to incorporate commodities into our asset allocation process. Over the last 25 years as a whole, our process would have generated significant outperformance on an absolute and risk-adjusted basis. This is achieved by systematically managing exposure to a limited number of commodities: oil, gold and copper only, and by actively managing a small number of other assets, spread across equities and fixed income. Passive exposures don’t work as well and too many assets create unnecessary and counter-productive complexity. The problem with including commodities is that US exceptionalism in equities, currencies and fixed income has made this strategy unattractive since 2010. If you think that this regime may be ending, it may be time to take another look at commodities.
Not with government bonds
Bonds don’t always go up when equities go down. In 2003, holding long-dated government bonds offset 50% of average local currency losses in developed equity markets. That ratio has fallen steadily in each of the following major sell-offs, 2009, 2016 and 2020. This year, it was effectively zero on average for the seven largest developed markets. For some countries, it was negative – i.e. bonds went down just when you needed them most.