In a previous Insights piece, we discussed how the investment landscape is evolving and key tailwinds are reversing in terms of the behaviour of interest rates, perceived riskiness of public debt, international trade, etc. These infrequent changes in market/macro regimes are complex and often lack a direct historical comparison. Asset allocation decisions are difficult in this context.
In this Insights piece, we provide a simple example of how we think about designing resilient portfolios. Allocators need a rich set of estimates and tools to do this. They need to know what is priced into markets, including the expected returns attached to a wide range of assets. They also need to understand how macro drivers can impact asset prices as macro regimes shift. Finally, they need a model of markets and macro that brings all these components together, that can be used to evaluate alternative asset allocations.
Designing macro-resilient portfolios
Elevated macro uncertainty means investors confront many different possible scenarios. It is not difficult to imagine entering a period of significant stagflation, but we could also face transformed global growth in an AI-era, or experience a global or regional lost decade. To get us started on thinking about macro resiliency, we don’t try to tackle everything at once, but in this article we concentrate on stagflation concerns.
To illustrate some key considerations for building a macro-resilient portfolio, we present a simplified case study for building an inflation-resilient portfolio. We take the perspective of a US-based, long-term investor, and use a US 60/40 portfolio as a benchmark.
We assume this investor dislikes inflation and low growth, without being specific about the sources of these concerns. As noted before, portfolio resilience is best defined by thinking carefully through investors’ objectives and constraints – and modelling these jointly with asset markets – but we bypass this consideration and pick a concern that is common to many types of investor.
An inflation-resilient portfolio
There are intuitive ways in which to build the inflation resilience of a portfolio. Inflation-linked bonds are an obvious choice, while we have also noted the inflation protection embedded in Gold, and equity sectors such as Real Estate and Energy. The implications of adding these assets to a 60-40 benchmark are more complex, however. One question is whether the portfolio expected return can be maintained when replacing 60-40 assets with inflation-protecting ones. In other words, how much investors must pay for insuring their portfolios against adverse macro outcomes. Another question is whether the inflation-protecting assets lead to added risk along other dimensions, as these assets should be seen as bundles of exposures to a range of macro drivers. This can be thought of as an implementation of a ‘Total Portfolio Approach’ to asset allocation.
As an alternative portfolio, we replace nominal US Treasuries in the 60-40 portfolio with inflation-linked Treasuries and gold. We also reduce US equity holdings and allocate that portion to European equities and Energy stocks. The table below shows the composition of both portfolios and the 30-year expected returns on their components. The change we make to the benchmark portfolio maintains the expected return at a similar level for the resilient portfolio.
| Asset Class | Proxy | Expected Nominal 30-year Return | Portfolio Weight |
|---|---|---|---|
| 60/40 US Portfolio | |||
| US Equity | S&P 500 | 5.22% | 60% |
| US Treasuries | Bloomberg US Treasuries | 4.94% | 40% |
| Resilient Portfolio | |||
| Inflation-linked Treasuries | Bloomberg US TIPS | 4.94% | 20% |
| Gold | — | 5.17% | 20% |
| US Equity | S&P 500 | 5.22% | 30% |
| EU Equity | EuroStoxx 50 | 5.33% | 25% |
| SPDR Energy | SPDR Energy | 8.35% | 5% |
This suggests that one can create an inflation-resilient portfolio without paying a price for the inflation insurance. This is an incomplete assessment, however. We need to be more precise about the degree to which the inflation-resilient portfolio protects investors against inflation, and also to understand the return profile of the alternative portfolio over the longer term.
Quantitative implications of resilience
To explore the macro-resilience of portfolios over the long term, we use simulated asset return and macro paths from our macro-finance model, offered as part of our Capital Market Assumptions solution. These are realistic sets of macro and investment outcomes across horizons, where returns are connected to macro drivers and carefully defined for long horizons. These simulations can be used as a laboratory for comparing portfolios across a full range of macro outcomes, and quantifying the expected return and risk impacts. The fan charts below show the distribution of nominal returns on the two portfolio alternatives out to a 30-year horizon.
Judging from the fan charts, the resilient portfolio delivers at least as good investment outcomes as the 60/40 portfolio — the worst outcomes are not worse than those of the benchmark portfolio. A closer look using the table below confirms that at longer horizons, the inflation-resilient portfolio delivers slightly higher average returns, with similar or lower volatility. Note that all statistics are produced by the simulation model and takes today’s market pricing into account.
| Horizon (years) | Expected Return | Volatility | ||
|---|---|---|---|---|
| 60/40 US portfolio | Resilient portfolio | 60/40 US portfolio | Resilient portfolio | |
| 1 | 6.74% | 5.89% | 10.11% | 11.19% |
| 5 | 5.49% | 5.61% | 11.32% | 9.52% |
| 10 | 5.39% | 5.75% | 10.12% | 8.71% |
| 30 | 5.58% | 5.81% | 8.46% | 8.71% |
The table above illustrates the issue with allocation decisions based on short-horizon risk-return properties. Based on the one-year return and risk estimates, an investor would still pick the 60/40 portfolio even though it clearly underperforms the resilient portfolio over the longer run. A related and perhaps well-known point is that standard deviation might not be the best risk measure for asset allocators, not least because it is disconnected from underlying macro drivers. Without links to macro, it is impossible to discriminate between different degrees of adversity in macro/investment outcomes. We are primarily interested in the performance of the two portfolios under a stagflation scenario. We define this as macro outcomes that jointly fall in the top quartile of inflation outcomes and lowest quartile of real output growth over the 30-year horizon. Once we have identified the subset of investment outcomes that fall into the stagflation scenario, we can compare the behavior of the 60/40 portfolio with the inflation-resilient portfolio. The charts below show distributions of returns only for simulation paths where inflation is high and growth is low. The fan charts show that the inflation-resilient portfolio delivers significantly better returns across horizons than the 60/40 portfolio. This applies to both average returns and worst-case investment outcomes.
To compare the investment outcomes more directly, the chart below shows the distribution of relative returns for the two portfolios under the stagflation scenario (the inflation-resilient portfolio minus the 60/40 portfolio). The resilient portfolio delivers a significant outperformance on average and performs better than the 60/40 portfolio in the vast majority of paths.
Taking resilience further
The case study presented here is a simplified example of how institutional investors can approach asset allocation. For now, we simply aim to illustrate some key considerations when using a forward-looking approach to portfolio construction and a consistent asset allocation framework connected to macro. All inputs presented in this Insights piece are available to our clients as part of our Capital Market Assumptions solution, which helps investors sharpen their asset allocation processes and navigate the challenging investment environment.
A more comprehensive asset allocation assessment would involve covering a wider set of macro scenarios that are important to investors. We would also explore baseline and alternative portfolios in more depth and with a wider set of asset classes and segments – including private assets. As the analysis grows, it is possible to bring in portfolio optimisation techniques. While not averse to this approach, we see optimisations as a complement to exploring portfolios in a more granular and explicit way. Following these steps helps investors to better appreciate the portfolio and macro trade-offs in their asset allocation decisions.
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