global perspectives

When bonds fail to hedge: the problem with conservative portfolios

When bonds fail to hedge: the problem with conservative portfolios
Alain Forclaz - Deputy CIO, Multi Asset

Alain Forclaz

Deputy CIO, Multi Asset
Florian Ielpo - Head of Macro, Multi Asset

Florian Ielpo

Head of Macro, Multi Asset

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we examine why the performance of ‘conservative’ portfolios has suffered from using fixed income to lower volatility, rather than cash.  


Need to know

  • The performance of ‘low-risk’ multi-asset portfolios has been very weak year-to-date and, in some cases, has even underperformed ‘higher-risk’ strategies, as bonds have declined as much as equities. This is very unexpected behaviour
  • Consequently, the realised volatility of conservative portfolios has risen sharply and the risk profiles of such solutions are now at risk of being revised, as per the SRRI classification, which would prevent some investors from accessing them
  • This calls into question the design of traditional conservative portfolios and demands a rethink of what conservative means, particularly the role that cash should play in sizing and controlling portfolio risk actively


Flawed allocations

Our industry has grown used to a very specific notion of ‘conservative’ and ‘dynamic’ portfolios since the period of disinflation in the 1990s. Given the diversification effect provided by government bonds, a conservative portfolio distinguishes itself from a dynamic portfolio by swapping some of its equity exposure for a greater bond exposure. In doing so, and given the diversification benefits that stem from fixed income, the conservative nature of the portfolio exhibits lower volatility – a stylised fact that has held true for over 30 years.

That is until this year. Even from a dynamic allocation perspective, portfolio risk used to be lowered by taking an overweight government bond position. Again, the phenomenon seemed reliable until this year. In our view, this way of reaching ‘conservatism’ is flawed. Actively sizing a portfolio and holding cash to a potentially high weighting if required, is a much better tool to explicitly control for how aggressive a portfolio needs to be.


Homogenous performance

The year-to-date performance of traditional balanced portfolios has been remarkably homogenous this year as shown in figure 1. Sadly, this was not a good thing. A portfolio allocation to equities may have varied from 20% to 80%, but the performance in 2022 has essentially been the same: about -15% through to 31 October. That is obviously not desirable for those investors at the low-risk end of the spectrum, where only 20% to 30% had been allocated to equities. This is particularly so because in the prosperous years, such portfolios benefited far less than dynamic portfolios (which held 60% equities or more) from the performance of equities – Table 2 shows the total performance over the 10-year period preceding 2022.

So where has the conservatism of conservative portfolios gone?


FIG 1. Performance of EUR balanced allocations


Source: Bloomberg, LOIM calculations. Equities: MSCI Europe; Bonds: Bloomberg Euro Aggregate. Monthly rebalancing. Gross of transaction costs and other fees. For illustrative purposes only. Past performance is not a reliable indicator of future returns.


Table 2. Total cumulative performance of balanced allocations from 31/12/2011-31/12/2021


Equity allocation











Source: Bloomberg, LOIM calculations. Monthly rebalancing. Gross of transaction costs and other fees.


That ship has sailed

How will this rise in realised volatility impact conservative portfolios? To put things simply, we think conservative profiles might not remain conservative in the future.

A well-known risk indicator, broadly used in client risk profiling, is the so-called Synthetic Risk and Reward Indicator (SRRI) which is traditionally published as part of the Key Investor Information Document (KIID) available for all European public mutual funds. According to this methodology, funds are classified in risk buckets based on their realised volatility (using weekly returns over a rolling 5-year window). This indicator ranges from 1 to 7, with 1 describing the least risky investments and 7 the most. Typically, conservative balanced funds fall into the SRRI level 3 category – which corresponds to a historical volatility of less than 5%. Based on representative allocations, portfolios with at least 20% equities are on a path to exceed this volatility level – see figure 3.


FIG 3. Volatility and SRRI classification


Source: Bloomberg, LOIM. (5Y rolling, weekly returns)


This trend is also visible in the mutual fund universe. Among all conservative funds (those with a volatility estimate that corresponded with an SRRI level 3 classification  a year ago) in the Morningstar Conservative Allocation and Moderate Allocation peer groups, about 90% have seen their volatility rise over the past 12 months as shown in figure 4. Furthermore, as it stands, we estimate that 40% of the funds with a volatility level below 5% as at a year ago are at risk of now exceeding this limit, which would put their SRRI in jeopardy. This simply means that 40% of SRRI level 3 multi-asset funds are at risk of being downgraded to level 4 (higher risk). Such a downgrade would make them ineligible to some of their current investors.


FIG 4. Volatility estimates among funds with a 5% volatility as of 12 months ago


Source: Bloomberg, LOIM


A call for risk-based investing

The year 2022, therefore, highlights the need to rethink the way conservative portfolios are built, in our view. The desired features of such investment solutions should include:

  • Performance that is truly defensive: this means better performance during the lean years than a traditional 60/40 portfolio which would come at the expense of worse performance during good years. Conservative solutions should trade some of the good years’ performance for better performance during market lulls
  • Risk profiles need to remain stable and consistent with pre-defined levels at all times – a genuine issue this year. This means applying active ex-ante risk controls that do not rely on statistical diversification but on explicit tools to adjust risk levels. Risk profile levels cannot be solely dependent on past diversification patterns, risk control needs to be explicit

There is only one known asset class that effectively makes it possible to explicitly control risk exposure: cash. To reach a target risk level, diluting risk into cash or adding to risk by increasing market exposure allows investors to keep a tight leash on their risk profile and therefore their SRRI.

We have advocated this approach for years – it is the bread and butter of risk-based investing. When the volatility of a diversified portfolio is too low compared to an investor’s risk profile, it can be leveraged to reach the target. Conversely, when risk is too high, or is rising as has been the case in 2022, diluting this diversified (but too risky) portfolio into cash makes it possible to stay in line with the product’s risk profile. The approach requires financial engineering, liquid investments and experience to reach its aim and is no easy feat; but we believe it represents a much better choice than a return to the old habit of using bonds to control risk.

Simply put, amid the war on inflation, bonds have failed defensive portfolios. Explicitly using cash and portfolio sizing controls is a more effective method of ensuring defensive portfolios remain defensive at all times – the raison d’etre of risk-based investing. 


Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

Our nowcasting indicators currently point to:

•    Worldwide growth is declining and recession risks are on the rise. The US signal continues to decline.
•    Inflation surprises will remain positive for the Eurozone but are declining elsewhere. The recent US inflation report shows a fourth decline in year-over-year inflation, consistent with the trend visible in our indicator. 
•    Central banks should remain hawkish. The ECB is notably likely to be more aggressive than expected.

World growth nowcaster: long-term (left) and recent evolution (right)

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World inflation nowcaster: long-term (left) and recent evolution (right)

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World monetary policy nowcaster: long-term (left) and recent evolution (right)

Multi-Asset-simply-put-Monetary Policy nowcaster-7Nov-01.svg

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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