Investment Committee – June 2022
Conditional correlation and the myth of portfolio diversification
Diversification is actually what we call conditional correlation. This is more evident this year, with some asset bubbles deflating, led by bonds. Debt/equity and debt/GDP ratios are coming higher despite the numerator remaining constant, because of stock prices and growth struggling.
Back in August 2020, we wrote an article on the 60/40 portfolio and the dangers of such an approach that is popular amongst the passive investment community. Nowadays, a common certainty amongst professionals is shorting such a portfolio!
A major issue may arise if a corporate needs to add or roll debt to a future expiration schedule – and the Committee is worried that this will need to occur at higher-than-current interest rates. Additionally, the reality of negative or historically low yields is changing the future of asset allocation and heavily challenges predominantly the fixed-income side.
Inflation attests we can’t rely on bonds for a diversified portfolio to perform.
Higher inflation is not necessarily bad news unless investors adjust appropriately. In this context we present some ideas that may help our readers to invest smarter within an inflationary environment:
- Diversify amongst factors: Factor-based investing offers better portfolio diversification. In KM Cube we actively invest in factors through our systematic strategies. For our frequent readers we have discussed factor-based investing several times in the past (see Factor based investing and alternative risk premia, Factor Investing Goes Mainstream).
- Add commodity risk: Commodity investing is a popular solution although not all commodities will show a significant correlation to inflation, particularly when that’s lower than, say, a 3% threshold.
- Add systematic strategies: Systematic strategies such as trend following offer an excellent way to hedge inflation.
- Diversify via alternative investments: Alternative investments offer diversification and allow investors to explore additional sources of premia through a variety of managers and strategies.
The main point is that although fundamentals have turned negative for the short- or even medium-term, this is already priced-in this year’s correction and any better-than-expected macroeconomic data may positively surprise investors and drive asset prices higher. Within this context, along with the Committee’s unanimous view that central banks will definitely remain accomodative against any severe market price drop, we suggest clients remain invested in mainstream assets such as stocks and bonds, and seek to diversify via alternative investments like absolute-return funds offered through KM Cube’s platform.