Easy Allocation Models ‘Doomed’ as Diversification Breaks Down

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  • Stocks, bonds, commodities move in lockstep amid volatility
  • ‘Investors will have to work harder’ to hedge risk: Bernstein
Rupert Watson, head of asset allocation at Mercer, discusses possible market contagion.

Finding shelter from stormy markets is getting harder than ever.

Major asset classes have been trending together to levels rarely seen over the past decade and, more often than not, that trend has been down. Investors who enjoyed easy gains as markets rose in sync in the past six months are struggling to find securities that move in opposition, leaving them exposed to losses even if they’re diversified.

Once immune to geopolitics, proposed U.S. tariffs have sent global stock markets lower. But bonds aren’t offering much of a fallback option, as reflationary threats and hawkish central banks hobble returns. Hoping commodities will provide a haven? Too bad. Crude and copper futures are extending losses after a hefty February decline.

“It doesn’t look like things that helped in the past like gold or bonds will be a safe haven, and they won’t do well in a rotation,” said Colin McLean, founder and chief executive officer of Edinburgh-based SVM Asset Management, which manages about $870 million. “Not many institutions can shift too much into cash a one point in time, and they’ve tended to build up diversification as a defensive strategy.”

Last month, cross-asset correlation registered the fourth-largest jump amid a markets-wide selloff, according to data compiled by Credit Suisse. In-tandem swings have yet to abate, as the bank’s cross-market contagion index sits in the top decile of its 10-year history.

One side effect of rising correlations: traditional 60/40 asset allocation models “are doomed,” according to Sanford C Bernstein & Co. The DFA Global Allocation 60/40 Portfolio slipped 2.8 percent last month, the steepest decline in more than two years. Prior to February, the fund had risen for 15-straight months, the longest streak since its inception in 2003.

“Investors, whether they realize it or not, have been able to get easy diversification in recent years as bonds and equities have been the most negatively correlated in 250 years,” the firm’s quantitative research team, headed by Inigo Fraser-Jenkins, wrote in a note last week. “This is unlikely to persist. Correlations are set to rise and investors will have to work harder to achieve diversification.”

The MSCI World equity index, an unhedged Bloomberg Barclays Global Aggregate bond index, and crude and copper futures all posted declines last month, falling as much as 4.5 percent.

Still, not everything has been hypnotized into same-way moves, according to Peter Sleep, senior money manager at Seven Investment Management LLP, which oversees about $12 billion. He’s used the British pound, which he describes as a risk-on currency, as a diversifier, while investing in both U.S. and European assets.

“Certainly everything went up in tandem six months ago and things are selling off in tandem,” said Sleep. “But as a U.K. investor, there are other approaches we can take as diversifiers.”

Others have gone further afield, moving into off-market assets like infrastructure or private equities, said Rupert Watson, head of asset allocation at Mercer Ltd. in London.

“There are things you can do -- the simple diversifying into non-listed things, a good sprinkling of hedge funds in there,” Watson said in a Bloomberg Television interview. “I don’t think you should kid yourself that portfolios will be as diversified as they have been in the past.”

For asset allocators unable to venture into illiquid markets, they’ll be coping with a lack of natural hedges during periods of market rotations, according to SVM’s McLean. The prospect of heightened correlations and poor returns has pushed money managers to more closely match the benchmarks, he said.

“When there’s a big market rotation, the worst thing that can happen is not only that you go down, but you underperform,” McLean said. “You don’t generally lose business just by going down, so people tend to get closer to benchmarks.”

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