The traditional asset allocation mix of equities and high quality bonds is now “dangerous”, according to Hawksmoor, which warns that continued loose monetary policy from the world’s central banks has caused correlations between bonds and equities to rise to worrying levels. 
Most areas of financial markets have enjoyed a stellar time of it over recent weeks and months.
Though a vote for Brexit during June’s EU referendum was initially thought to be cataclysmic for investors, the FTSE Actuaries UK Conventional Gilts All Stocks index and the FTSE All Share have rallied 8.38 per cent and 6.55 per cent, respectively, since Leave’s victory.
Performance of indices since the EU referendum
Source: FE Analytics
There have been two major drivers behind this rally. First and foremost, the immediate sell-off in risk-assets the day after the vote was deemed by many as well overdone.
Secondly, though (and more importantly), the Brexit vote led most to believe the Bank of England would have to react with looser monetary policy – a prediction which duly came true last week after the MPC slashed rates to 0.25 per cent and embarked on a surprise quantitative easing programme.
While both bonds and equities reacted very positively to the announcement (10-year gilts now yield 0.6 per cent while the FTSE 100 is trading at 6,830), the team at Hawksmoor – which includes Richard Scott, Daniel Lockyer and Ben Conway – says investors should not be carried away by recent returns.
“While recent events are seen as negative for corporate earnings in aggregate, equities as an asset class have been in demand given the higher valuations lower interest rates are commonly thought to justify,” Hawksmoor said.
“In the light of the background described above we believe it is important not to have portfolios dependent on the largesse of central banks to perform well.”
“While circumstances are such that it is hard to see any significant changes in the interest rate environment, it is perfectly possible that investors could be caught by surprise by higher rates just as they have been continually caught by surprise by the extent to which rates have fallen.”
“Indeed, it is hard to overstate how extraordinary the current environment is in terms of the levels of interest rates and government bond yields.”
The extraordinary nature of the current environment, according to Hawksmoor, is highlighted by the fact it is now extremely difficult to generate diversification within a supposedly “diverse” portfolio.
“These are not normal times, and we believe the traditional model of a balanced portfolio that consists of a mix between high quality bonds and equities is a dangerous approach because the performance of the two asset classes is becoming increasingly positively correlated,” the team added.
Certainly, this mix of equities and bonds has worked phenomenally well for investors over the longer term.
According to FE Analytics, an example of a traditional asset allocation mix of bonds and equities (40 per cent equities, 40 per cent government bonds and 20 per cent corporate bonds) would have returned 451.75 per cent over the past 25 years.
Performance of model portfolio over 25yrs
Source: FE Analytics
On top of that, this mix would have delivered a maximum drawdown of just 22 per cent, an annualised volatility of 7.99 per cent and a positive return in 21 out of the past 25 calendar years.
The reason why this mix has worked so well is due to the fact that equities and bonds have historically been lowly correlated, with equities tending to perform well during periods of risk on and bonds coming into their own when sentiment dropped.
However, monetary policies such as ultra-low interest rates and quantitative easing not only push down bond yields, but have led to equity market rallies as investors have needed to take greater risk to find an acceptable yield/return.
According to FE Analytics, this has meant that correlations between equities and bonds have jumped 0.5 so far in 2016 compared to an average correlation of -0.11 since 2000.
Correlation between bonds and equites and performance of model portfolio since 2000
Source: FE Analytics
The chart above shows the returns of our example of traditional asset allocation portfolio in annual calendar years and the correlations between bonds and equities in each of those years. As it clearly show, correlations have become increasingly positive since 2012 (the year in which the US Federal Reserve initiated its unlimited QE3 programme).
Correlations between gilt prices and the FTSE All Share have only spiked further since the EU referendum as both asset classes have rallied, leading many to believe that ‘what goes up together, must come down together’.
As such, the team is attempting to make sure that its MI Hawskmoor Distribution and Vanbrugh funds are as diversified as possible.
“This makes for challenging conditions for investors, and recognising this we have been seeking to ensure the funds are focused on assets where we believe there is some margin of safety, primarily through valuations which appear to offer a positive balance of potential upside rewards to downside risks should conditions change,” Hawksmoor said.
“This approach explains the funds’ exposure to areas of markets which are relatively unpopular with many investors, such as emerging market debt, and niche sectors that are not widely considered, such as Berlin residential property.”
“Such holdings are part of overall portfolios consisting mainly of large holdings in conventional corporate bond and equity funds managed by those who share our philosophy that ultimately the best way to contain risk is to avoid the permanent loss of capital.”
In the £70m MI Hawksmoor Vanbrugh fund, which has the longest track record, the managers currently hold a vast array of different assets. The fund has 34.6 per cent in listed equities, 5.9 per cent private equity, some 29.7 per cent in fixed income (across sovereign, corporate and convertible bonds), 9.2 per cent in property, 10 per cent in absolute return funds and 7.7 per cent in cash.
This highly diversified approach, which is founded on a value-orientated strategy, has delivered decent total and risk adjusted returns since the fund’s launch in February 2009.
Performance of fund versus sector since launch
Source: FE Analytics
According FE Analytics, it has been the third best performing portfolio in the IA Mixed Investment 20%-60% Shares sector with returns of 126.36 per cent (beating its average peer by 54.11 percentage points in the process) since inception.
It has also topped the sector for its Sharpe ratio over the period in question.
