Portfolio resilience: rethinking the foundations

The ground beneath the idea of portfolio resilience has shifted in the ‘turbulent twenties’ – how can allocators adjust? We explore this question in the latest bfinance Allocator Briefing, as assumptions which withstood the zero-interest-rate (Zirp) policies following the Global Financial Crisis (GFC) come under debate.

bfinance advisor Kathryn Saklatvala, and co-host Toby Goodworth (Head of Liquid Markets), were joined by Mathias Neidert (Head of Fixed Income), Martha Brindle (Senior Director, Equities) and Pravir Sharma (Director, Diversifying Strategies). In a more fragmented and uncertain world, they explored how foundational tenets of modern portfolio theory are being scrutinised, including the negative equity/bond correlation, among other important aspects of resilience.

They debated whether allocators are trading relative risk for absolute risk in equities, if the shift toward floating-rate debt instruments has left portfolios light on duration (and exposed to the risk of an economic downturn), and how to adjust to ever-shifting macro regimes. “Resilience is the ability to adapt,” Goodworth summarised. “Foundational assumptions have changed. What has worked in the past isn’t necessarily working now.”

For the full version of the Allocator Briefing click here

For the bolded terms please see the glossary at the foot of the article.

Are allocators trading relative risk for absolute risk in equities?

Allocators are currently focused on managing relative risk in equity portfolios, with a shift toward systematic and index-aware type equity strategies, and away from portfolios where factor exposures differ materially from the reference benchmark. Weak relative performance from active managers – particularly style-focused managers – during the 2020s has contributed towards the shift, explained Brindle.

Martha Brindle: “What we’re hearing today from investors is that the sustainability of alpha really matters. So it’s not really about the level of returns it’s about the path of returns. For a lot of allocators, a slightly more moderate relative performance profile that’s more predictable would actually be preferred to a higher alpha level long-term.”

Yet does lower relative risk mean lower absolute risk? Probably not, argued Brindle, pointing to “eye-watering” valuations, a disconnect from fundamentals and the increased prominence of momentum, both in markets and fund managers’ investment processes. Indeed, July’s momentum reversal briefly highlighted the risk of investors “trading down relative risk but buying into the absolute risk – whether that’s index concentration or valuation”.

Martha Brindle: “There’s the big element of retail investors in the market now, if you think of things like the NVIDIA earnings parties or SpaceX there’s this real role of the individual driving markets, so that momentum / sentiment element can’t really be ignored. Active managers do have to take account of it. We are seeing more and more managers (not just on the systematic side but also discretionary stock pickers) thinking about that role of momentum and sentiment driving price. … The managers are adapting [investment processes].”

Have allocators cut back too much on duration exposure?

The 2022 breakdown of the negative equity/bond correlation has certainly left question marks over the diversification ‘free lunch’. It’s far from certain, however, that this foundational tenet of modern portfolio theory is dead, argued Neidert. It was, he said, predictable that the negative equity/bond correlation relationship would be tested in an inflationary environment, and indeed, since peaking in 2022, the correlation coefficient has trended back towards historical norms.

Importantly, fixed income’s role as a tail risk hedge needs to be considered, when viewed as a duration “long put” against a severe equity market correction linked to economic rather than inflationary concerns.

Mathias Neidert: “Certainly this is one of the key questions that institutional investors are asking themselves at the moment: ‘do I have enough duration in my portfolio?’ The answer is rarely a straight yes. Given the fiscal situations of some governments, investors have hesitated in holding government bond positions and many have been tempted to reduce exposure alongside which we’ve seen a rise in new asset classes.

“Private debt has been popular, and for many good reasons, but one key characteristic of private debt is that this is a floating-rate asset with, in theory, zero duration, and with the trend of accumulating private debt exposure the overall duration in fixed income portfolios is relatively low.”

How can portfolios adjust to a changing macro regime?

Unfortunately, not all periods of market difficulty are created equal, explained Sharma. He elaborated on how different tools will provide resilience to different forms of drawdown and their efficacy will vary in different regimes. Various diversifying strategies in liquid markets may require reconsideration or re-validation in the 2020s – adaptability, flexibility and (unfortunately) complexity may all be required in the search for ‘all-weather’ portfolios solutions fit for purposes in the turbulent twenties.

In particular, weaknesses demonstrated by conventional 60:40 diversification since 2022 have increased investors’ focus on less conventional tools, he argued.

Pravir Sharma: “Historically, if there was a conversation about resilience, it was about mitigating equity losses. That has shifted towards how hedge funds not only address that question of equity risk mitigation but also how they diversify the traditional diversifier of government bonds. There is much more commonality in the underlying risk factors driving a 60:40 portfolio in this era than the prior era.”

A number of hedge fund styles have provided strong performance in the 2020s, in contrast to the often-anaemic returns generated in the “beta era” of the 2010s, explained Sharma. As such, it is important to consider hedge funds in the context of regime rather than relying purely on historic data that spans multiple regimes. Strategic asset allocation analysis should be tailored with that in mind.

“You move into the post-Covid era where that average VIX index has increased by about 50%. That’s a much more useful area for hedge funds to operate in.”

For the full version of the Allocator Briefing click here

For the terms bolded please see our glossary below.

Glossary

Alpha: The portion of an investment's return attributable to a manager's skill, above what the market benchmark or underlying risk exposures would have delivered on their own.

Beta era: The 2010s, when returns came largely from broad market exposure (beta) rather than manager skill. Simply holding the market paid off, so active and hedge fund strategies added little.

Correlation coefficient: A statistic measuring how closely two assets move together, ranging from +1 (moving in lockstep) to -1 (moving in opposite directions), with zero meaning no relationship.

Duration: A measure of how sensitive a bond's price is to interest rate changes. Longer duration means larger price gains when rates fall, which can cushion equity losses during economic downturns.

Long put: An option position that gains value if an asset's price falls, acting like insurance against declines. It costs a premium upfront but pays off during severe downturns.

Modern portfolio theory: A framework for constructing portfolios that combine assets to maximise expected return for a given level of risk, relying heavily on diversification across investments that behave differently.

Zero-interest-rate (Zirp) policies: Central bank policies, common after the 2008 Global Financial Crisis, that hold benchmark interest rates at or near zero to stimulate borrowing, spending and economic growth.