Gold is known as the great diversifier, but experts are unconvinced that it will protect investors at present. While it has historically been shown (if held in certain amounts) to increase risk-adjusted returns and decrease maximum drawdown in portfolios, experts aren’t recommending adding to it now.
Without the classic safe haven, where can investors allocate should equities and bonds succumb to a recession?
Some could argue that bonds and equities are enough and that a traditional 60/40 split will do the trick, but Darius McDermott, managing director of Chelsea Financial Services, doesn’t think so.
Equities and bonds “are not enough on their own”, although they can provide diversification if used selectively.
“In our portfolios we use renewables. They are technically equities and will behave like them in the very short term, but they are on big discounts already and the underlying assets are uncorrelated,” he said.
“Within bonds, I would highlight government bonds. In a risk-off market, they would do a decent job of insulating a portfolio from the worst of it.”
After mentioning property and infrastructure, which also work as alternatives, McDermott noted how today for the first time in a decade, cash is a viable alternative.
“You can get more than 4% interest and, while inflation will erode its value over time, it wouldn’t lose value in a sell-off like other assets so does add the diversification element,” he concluded.
Will McIntosh Whyte, fund manager on the Rathbone multi-asset portfolios, agreed with many of McDermott’s ideas and pointed out how fixed income, equities and traditional alternative investments can behave very differently in normal times, but correlate during periods of market stress – as happened last year.
“This is why we prefer to categorise assets by their liquidity and correlation to equities in market downturns, instead of by their headline asset class. Finding genuine diversifiers can better protect our portfolios during these times when it matters most,” he said.
Government bonds fit the description for Whyte too.
“While they failed to provide any protection last year, they are now providing a much more attractive yield of more than 4% and, in the US, treasuries are providing a healthy real yield (a positive return after inflation),” he said.
“From this point on, they can return to play an important role in multi-asset portfolios as a risk-off buffer with a more negative correlation to equities. In an environment where we may see weaker growth and disinflation driven by tight monetary policy, government bonds are likely to rally, and help buffer portfolios in an environment likely to be difficult for equities.”
Then, to diversify away from just government bonds and equities, Whyte said that the best way to protect against stubborn inflation and further base rate hikes is to cherry-pick “genuinely diversifying” investment strategies which take advantage of market inefficiencies or provide protection against specific risks through “bespoke structured products”.
For example, an interest rates volatility product.
“These benefit from any unexpected bond market moves as a result of changing inflation sentiment and any surprising moves from central banks. The rates volatility investment can therefore benefit from spikes in bond yields and help protect the portfolio in taper-tantrum-like environments,” he said.
“Importantly, the direction of the move in yields is irrelevant, so the investment can also benefit from plunging bond yields in a more typical crisis environment.”
Put options are also “a vital instrument” to help weather some of the more turbulent times in markets, being one of the few investments you can be certain of to have a negative correlation to equities. They are rarely cheap and so, to keep an eye on cost, Whyte buys them into equity strength when volatility, and therefore option premiums, are low.
Finally, not everyone agreed with the assumption to avoid gold. Kelly Prior, investment manager in the multi-manager team at Columbia Threadneedle Investments, currently likes the metal due to its risk-off diversifying characterises and longer-term inflation protection. For those looking for an alternative, however, she suggested cash.