Portfolio protection is at the forefront of investors’ minds, for good reason. Investors are asking how their assets will fare in the next downturn and what they can do to build more resilient portfolios. 
Classic portfolio theory points to diversification – like allocating to 'safe haven' assets (such as high-quality sovereign bonds) in a balanced portfolio to help protect against losses.
Does that principle still hold? And if it doesn’t—or if its meaning has shifted in subtle but important ways—what does that mean for portfolio construction?
For many multi-asset investors, sovereign bonds have been the traditional safe-haven assets in balanced portfolios. The accepted trade-off for adding a safe haven asset has been that investors would forgo some of the higher expected returns from risky assets like stocks in return for a lower expected “risk-free” return from bonds.
Until recently, this assumption held: bonds provided both income and capital return, so that investors were effectively being paid for adding portfolio insurance. That changed with the implementation of unprecedented monetary policies following the global financial crisis.
Today a substantial proportion of developed market government bonds now have negative or near-negative yields. So for the first time in modern financial history, some investors effectively have to pay to add bonds to a portfolio. One might well ask whether the concept of a “risk-free return” has been exhausted.
With the advent of negative bond yields, the opportunity cost of holding bonds is plainly rising and their effectiveness in protecting portfolios is coming under scrutiny. This demands a more careful analysis of safe-haven assets and their trade-offs from a specific investor’s perspective. Most importantly, it necessitates devoting as much attention to efficiently building portfolio ballast as to optimizing returns.
Until now, investors have been unusually compensated for protecting balanced portfolios by the positive coupons on bonds. In our view, high-quality bonds will remain viable safe-haven assets during the next 10 to 15 years, given our expectation for muted inflation. Bonds are likely to provide a return of capital – even if they don’t provide return on capital. They also offer protection in a market downturn and the liquidity required to take advantage of dislocations. Crucially, however, we do not see bonds as a major source of income or return on capital, and there are opportunity costs associated with holding bonds, especially at current low, and sometimes negative, real yields.
Bonds have been a traditional liquid store of value and have offered protection against growth shocks. But low starting yields diminish the protective power of bonds. At best, bonds now provide only a modest cushion against inflation. At worst, investors may lock in a capital loss in the case of negative-yielding debt — a new trade-off that investors will need to weigh that is much more tangible than the concept of opportunity cost.
Reserve currencies and gold are two other traditional safe havens; both involve an implicit trade-off in terms of market risk and return. There are also less traditional safe-haven assets within alternative strategy classes, for investors willing and able to forgo liquidity for a steady income stream.
Core real estate and infrastructure are illiquid by nature, but they can help provide investors with a key survival skill: keeping cash flows stable to meet required outflows — something many sovereign bonds can no longer do.
Both traditional and alternative assets may exhibit safe haven properties that can be mapped to particular types of portfolios. Crucially, our research demonstrates that there is no single, perfect safe haven asset; rather, different assets protect against different risks, and their relative effectiveness and opportunity costs vary. Investors, too, vary in the relative importance of the risks they need to protect against.
The good news is, investors may have more choices for building protection and resiliency into their portfolios than they think. Expanding the concept of safe-haven assets to include not only bonds, reserve currencies and gold but also selected alternative assets is a good starting point. Investors should then consider what they really need to successfully navigate periods of market stress (in our view: staying solvent, meeting cash flow obligations, being nimble enough to seize investment opportunities) and what trade-offs they are more or less willing to make to achieve their investment objectives.
The solutions may be surprising, and the most appropriate trade-offs will vary across investors. Long-term investors who can warehouse volatility without being forced to sell can harvest income returns from core real assets that exhibit low beta to equity markets, for example. In contrast, for investors who are more focused on mark-to-market performance and face capital outflows but have low cash flow obligations, more liquid safe-haven assets such as gold, cash and bonds may be more attractive.
Answers will vary but one thing is clear: with persistently low rates and a mature economic cycle, investors should spend as much time focusing on the risk parameters of their portfolios as they do fortifying returns.
Thushka Maharaj is global multi-asset strategist at JPMorgan Asset Management. The views expressed above are her own and should not be taken as investment advice.