Funds to diversify away from shares and bonds after both fell in 2022

Holding a mixture of shares and bonds has not paid off in 2022. Should investors consider adding some alternatives to their portfolio? Cherry Reynard shares some fund ideas.

Conventional wisdom is that a portfolio that includes some stock market investments, government bonds, perhaps infrastructure or commercial property, will see an investor through the highs and lows of the economic cycle. However, this has been a spectacularly unsuccessful strategy in 2022, with a near-universal sell off across financial markets.

Just as low interest rates have buoyed almost all financial assets for much of the past decade, the abrupt reversal in the interest rate cycle has been punishing. UK government bond and technology funds are down an average of 23% and 21% respectively (according to FE Fundinfo, to 12 December 2022). These assets may have looked superficially different but have proved highly correlated just when investors needed them not to be.

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Even areas that would normally be safe havens in an inflationary environment - inflation-linked bonds, gold or infrastructure assets – have been weak, dragged lower by higher interest rates. The problem is that interest rates influence the valuation of almost all conventional assets, even gold. Investors could not escape the clutches of central bank action.

Do alternative assets make good bond substitutes?

Tom Boyle, manager of the Atlantic House Uncorrelated Strategies fund, points out: “The problem is that if you break these funds down to their bare bones, infrastructure and property are not all that different from bonds. Instead of coupons paid by a bond issuer, investors get rent or some other income associated with the underlying asset, whether that be a hospital, toll road or wind farm.

“During a period of low interest rates, there is little reason for investors to hold money in the bank as that money in a year’s time is worth little more than the money is today. As rates rise however, the return on cash in the bank increases too and investors expect to earn more from other assets to compensate for the additional risk they take, compared to ‘risk-free’ cash.”  

When the base rate is 0.25%, most assets with an income of 3-4% will look attractive, whether that is infrastructure or emerging market debt, but when investors can get 2-3% on a savings account, they won’t have the same appeal. As a result, when interest rates are rising, a lot of previously uncorrelated assets will move in unison.

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If this diagnoses the problem, it does little to help investors know where to look from here. Interest rates are likely to rise into 2023 and inflation pressures are still in evidence. However, James de Bunsen, portfolio manager on Janus Henderson Investors' UK-based multi-asset team, cautions against moving away from assets such as infrastructure just because interest rates may still be rising: “High-quality infrastructure is still a good investment and still has some inflation protection – and inflation is a big worry.” He points out that while infrastructure is influenced by rising rates, it is not the only, or even the main, factor in pricing.

This exposes the central problem with many conventional approaches to diversification: they assume it is static and works in all environments. In reality, assets that are correlated in one environment may be uncorrelated in another. Bonds and equities are diversified from an economic growth point of view – equities rise when economic activity is high, while bonds do well in a more deflationary environment – but aren’t diversified from an interest rate point of view.

There is also a danger that investors abandon these assets just as the interest rate factor becomes more benign and the recessionary environment becomes more important. If interest rates stabilise next year, bonds, infrastructure and other similar assets may start to offer a diversification benefit once again and may protect investors against a weaker economic environment. “They have less sensitivity to GDP and their earnings are stable,” de Bunsen adds.

Tread carefully with uncorrelated funds 

However, at the moment, markets remain focused on interest rates. For investors who want completely uncorrelated assets, hedge fund type strategies, which focus on relative returns rather than relying on market direction, can provide a solution. For the most part, these are found in the Investment Association’s Targeted Absolute Return sector. However, it is an extremely mixed bag, notes Charles Hovenden, portfolio manager at Square Mile Investment Consulting and Research. Hovenden cautions that investors need to be careful: “A lot of the funds in this sector are not fit for purpose. It doesn’t do what you want it to do.”

However, Hovenden highlights funds such as the BlackRock European Absolute Alpha fund that have provided strong returns, uncorrelated to European equity markets. It is down just 1.1% for the year to date (source: Trustnet to 11 November). He adds: “These need to be market neutral, a proper hedge fund in retail form.” He also likes the Janus Henderson Absolute Return fund, although this has more market exposure.

Another option is global macro-style funds. These have a portfolio of bets, based on where the manager sees opportunities in the market. They might be short UK government bonds, for example, long energy, long the dollar and long inflation protection all in one portfolio.

In general, Hovenden doesn’t invest in them: “I’ve never found a fund that is consistent. They make binary bets, which are right or wrong and few have a reliable hit rate.” That said, there are some funds that have done a good job – he highlights the TM Fulcrum Diversified Absolute Return fund. He also likes the LF Ruffer Total Return fund, which is a multi-asset fund, but with some features of a global macro fund: “Its special sauce in its ‘protection strategies’ – it employs options to protect against market movements in specific areas," he says. Most recently, it has employed these for inflation management.

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De Bunsen likes systematic global macro strategies, where the trades are automatic, based on market movements. He likes that these funds take the emotion out of the trading decision. Bond yields have moved a long way recently and there is a question over whether they can go further. For a systematic strategy, it will depend purely on market momentum: “It allows a dispassionate view,” he says.

The Atlantic House fund focuses on volatility, which means that its strategy benefits most at times of market shock. Boyle says: “We look to benefit from prices moving around in an unpredictable way. When rates are low and everything is a bit calmer and areas such as property are doing well, this approach may not be as interesting, but when prices begin to move, strategies that benefit from higher volatility tend to thrive. When you measure volatility, you don’t care about its direction, 1% up and 1% down are the same.”

This is an important point to bear in mind. Investors need to be prepared for uncorrelated funds to be boring much of the time: De Bunsen says: “We don’t mind if these assets don’t do much in a bull market. We want them to kick in when markets are difficult.”

Cash is king once again 

In ensuring diversification, liquidity is another consideration. All risk assets will tend to correlate when there is a market shock and lots of investors are trying to exit the market at the same time. This was evident during the global financial crisis, when only cash, gold and government bonds protected investor capital.

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Cash has become very unfashionable in recent years, but it may have a place again today as interest rates rise. Hovenden says: “In 2022, investors have had a 2% return from cash, or thereabouts. Adjusting for inflation, that might be a loss of around 8%.

“However, in bonds, equities and some alternatives, that loss may be as higher as 20-30%. Inflation will probably drop next year, so if investors can get a sensible return on a deposit, it may be worth doing.” Cash has a place as a diversifier and can help bring some optionality to a portfolio.”

The reality is that it is very difficult to find assets that are uncorrelated to equities and bonds in all environments. Assets that are not correlated in normal conditions, may prove highly correlated when interest rates or rising, or when liquidity is scarce.

Equally, now may not be the right time to be abandoning strategies with interest rate exposure just because they have been weak recently. That said, selective investment in truly diversified absolute return strategies and cash can build protection in a portfolio.