Insights – Interest Rate Risk and Asset Correlations with Future Cash Rate Expectations

"Is the All Seasons Portfolio strategy not working anymore?"

With an annual drawdown for such portfolios almost as bad as for the stock market YTD (S&P 500 currently being down 16% since 1 January, having briefly been below -20%), I am not surprised that I have been hearing this question more and more recently. Is this a bug or a feature?

The first seven months of 2022 can be illustrated by two major themes in terms of financial markets: a) significant underperformance of major asset classes such as stocks and bonds, and b) rising rates.

The latter constitutes one of two undiversifiable risks for investors, as when the cah rate rises, that impacts asset prices as returns of risky assets always compete with the return of cash.

In this article, we explore interest rate risk and how most major asset classes have correlated with the future cash rate expectations over the first seven months of 2022. We try to answer the question on if the All Seasons Portfolio strategy is broken, or if the playing field has been reset and that we can expect better performance ahead.

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Portfolio Update – January 2022 – Interest Rate Risk

January 2022 was a shaky month for capital markets, and this turmoil has continued into February as well.

Russia’s invasion of Ukraine’s and a severe violation of a free nation’s sovereignty has certainly caused much volatility on the markets. But the fact is that while conflict is leading to a changed world with a new world order, it is actually not the sole culprit for the turbulence we have seen at late.

Sure, the was has a great impact on commodity prices (more on that later), as, firstly, the sanctions limiting trading with Russian oil, takes a vast amount of barrels of oil off the market on a daily basis, which certainly will drive up prices.

But the fact is that the main driver of asset prices is not the war in Ukraine, but still the same story as has been told since December 2021, namely inflation and expected interest rate hikes.

Interest rate risk is an important type of risk to be aware of as an investor, as it affects stocks and bonds indiscriminately. That is especially harmful for investors only investing in stocks or using a "balanced" stock-bond portfolio.

We will therefore be taking a closer look at what it is and whether there is anything we can do as investors to protect our wealth and portfolios against it.

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Portfolio Update – December 2021 – How Roll Yield Influences Bond ETF Performance In Rising Yield Environments

Recently, a lot of discussions have been revolving around government bonds and whether they are still a sensible investment even in a balanced portfolio such as the All Seasons Portfolio, now that yields are rising and the West could be facing geopolitical uncertainty.

When attempting to find answers on what to do with treasury bond investments, I began thinking about how roll yield could potentially be an important factor to consider when assessing bond returns. I will be explaining more in detail what that is further below, but I think you might find it interesting too how roll yield is likely to impact Long-Term Treasury ETFs like IS04/TLT (iShares $ 20+yr treasury Bond ETF) in a scenario when rates rise.

As I searched for more certainty what will happen with these investments, I sought to quantify the impact of roll yield. To achieve this, I modelled the returns by simulating 100 bond portfolios similar to IS04 in the event that rates would rise, and compare that return with a portfolio that does not benefit from roll yield to see the difference. The results were quite clear actually.

With this post, I am not attempting to convince you that investing in government bond is a good idea - I give no judgement in that. Rather, I share my observations and findings from my research about roll yield as a phenomenon, and you can use that information as you wish in your analysis. I hope it adds to your process.

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Portfolio Update – October and November 2021 – Strategic Rebalancing

It is December, and this is a period when most investors usually end up overseeing their portfolio allocations to start fresh in the coming year, and preforming periodical rebalancing.

While most just rebalance mechanically back to the original asset weights, we will be looking at whether rebalancing can be carried out in a way that improves returns and minimizes drawdowns when compared to both buy-and-hold strategies, as well as periodical rebalancing.

Many investors – both retail investors investing their personal wealth, and asset managers with millions in AUM – usually employ calendar rebalancing of a portfolio. This could be the quarterly rebalancing of a mutual fund, or that the retail investor sits down annually for a few hours during the Christmas holidays ahead of the new year to rebalance the portfolio.

Such periodical rebalancing is built on the fundament of mean reversion. It essentially sells the winners of the past period, and buys the losers. Over time, this is from where a rebalancing premium is captured when your portfolio consists of several uncorrelated assets. All Seasons Portfolios are a typical such portfolio that benefits from the rebalancing premium.

However, Man Group has researched strategic rebalancing techniques that could mitigate drawdowns through more bespoke methods for rebalancing. Their discussed techniques cover both the periodical rebalancings, as well as mid-period rebalancing when assets’ weights in portfolios deviate by more than a predetermined amount (rebalancing spans).

The retail investor should therefore consider the implications of trend and momentum both for periodical rebalancing and ad hoc rebalancing when using rebalancing spans, and implement a strategic rebalancing approach to further improve risk-adjusted return by minimizing drawdowns and thus the overall portfolio volatility, and potentially capture additional percentage points of return from trend.

In this post, we will be looking at a few ways of how to implement strategic rebalancing for your portfolio. I will also especially highlight the ways I have taken strategic rebalancing to heart in my All Seasons Portfolio.

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Portfolio Update – September 2021 – Why The 60/40 Portfolio Is Not Balanced

When it comes to the All Seasons Portfolio strategy, or any other risk parity strategy for that matter, one of the fundamental ingredients is how to allocate the capital between assets in the portfolio based on risk rather than capital.

Why this is important, or even why bother doing it at all, is a question I get quite often. I think therefore it is time to have a closer look at risk parity portfolio allocation principles. Here I mean the reason for why the allocation to the assets is based on their risk (volatility) rather than equal weight based on capital.

In this article, for a comprehensible description, we will be examining a simple two-asset portfolio to illustrate the importance of weighting assets based on risk rather than capital. For this example, I will be using a 60/40 Portfolio consisting of 60% stocks and 40% bonds, as this is popularly (and erroneously) considered as a “balanced portfolio”, and as this is a portfolio allocation strategy among both retail and institutional investors.

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Portfolio Update – August 2021 – Retail Investors’ Irrational Expectations of Risk Parity

What I have observed from discussions with retail investors who are not yet aware of the benefits of risk parity, is that there is a great misunderstand of the goals of risk parity, and incorrect expectations of what such strategies should provide.

When explaining what risk parity is, being a strategy that pieces together risk premiums and returns from a wider array of asset classes, but where the timing of the earned positive returns from each asset are spread out in such a fashion that during all economic regimes, some of the assets will see negative returns, but the positive returns of other assets will offset losses and provide your portfolio with an overall profit.

This means that through proper diversification, on a portfolio level you cancel out much of the volatility inherit in each of the individual asset classes, so that you get a much smoother ride with lower portfolio volatility, but can still expect equity-like returns over time. You should expect rolling hills and valleys rather than mountains and canyons.

But as I have alluded to in recent posts, even though the All Seasons Portfolio strategy and other similar strategies (Golden Butterfly, etc. for example) are rationally the best fit for most investors, during times when the stock market outperforms, it becomes difficult to see your neighbor get richer on the stock market while your safe portfolio lags.

This kind of underperformance fatigue sets you up for a great risk if you abandon the safe strategy for a high-risk strategy when the market crash (the one that you were protected against) occurs.

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