Why your portfolio may have too much equity risk (Hint: It’s your bonds)

Industry-wide calls for interest rates to rise over the past five years may be inflicting an unintended toll on portfolios: Many are overexposed to equity and equity-like risk, with little to offset it.

When the Fed dropped its target short-term interest rate to the 0%-0.25% range in December 2008, many knew it would be there for a while, but once the economy showed signs of healing, many market participants prepared their portfolios as if they expected the rate hikes of the past — where movements were in percentage points, not basis points. Very few foresaw a 10-year U.S. Treasury rate hovering around 2.3% near the end of 2017.

As a result, despite calls of “lower for longer,” an over-reduction of bond sleeve durations has sapped portfolios of valuable diversification. At the same time, in a persistent low-rate, income-starved world, many stretched into higher yielding credit instruments seeking two things — more income and protection from rising rates.

The net result: portfolios have become unbalanced. They are overexposed to equity and credit risk, and underexposed to a natural diversifier of both: interest rate risk. While recession is not part of the near-term industry consensus, investors could still greater vulnerability to an economic shock or market selloff than intended.

INTENTION VS REALITY

This observation of a risk imbalance is based on BlackRock’s analysis of more than 850 multi-asset portfolios submitted by financial advisers. We asked them to identify the primary purpose of fixed income in their portfolios — seek stability, generate income or diversify equity risk. The portfolios were further segmented into conservative, moderate and aggressive buckets based on their percentage of equity assets.

Almost all portfolios that specifically identified bonds as a diversifier of equity risk, were still overexposed to that very risk.

BEST IDEAS VS BEST PORTFOLIOS

We often build portfolios of “best ideas” based on the prevailing market backdrop and opportunity set. This methodology is often focused on each sleeve individually, without sufficient consideration for how the sleeves balance each other.

When building a diversified multi-asset portfolio, your best ideas may not produce the best results. Stocks and bonds are distinct asset classes, with unique volatility profiles and drivers of returns. If they are to truly diversify one another, those risk profiles must be considered thoughtfully. Failing to do this merely produces a series of interconnected portfolio bets.

UNDERWEIGHT, DON’T DISCRIMINATE

While many investors are avoiding interest rate exposure, duration remains a useful tool to diversify against other dominant risks. Eradicating duration from bond sleeves can create other challenges the portfolio simply can’t address. Investors who may find their portfolios overexposed to equity risk, intentional or not, might consider the following for their bond sleeve:

1) Have a healthy exposure to high-quality bonds with some duration. This includes Treasuries, Treasury inflation protected securities (TIPS) and municipal bonds, or strategies that emphasize them. An ETF tracking the aggregate index works here too, as does a consistent core bond manager. Including them alongside credit instruments will help should stocks start to experience a bumpier ride.

2) Trade some credit exposures for a flexible strategy. Given that many unconstrained bond managers can lean heavily towards credit risk, this position is likely best paired with a core holding, like those described in #1 above.

3) Revisit heavy cash allocations. Cash dulls equity peaks and valleys, but doesn’t provide the counterbalance to an equity market decline that longer duration bonds typically would. If you’re seeking portfolio diversification, core bonds are likely a better bet than cash.

On the last point, BlackRock’s recent Global Investor Pulse survey found that Americans still hold an average of 10% of their investable assets in cash. That may represent an opportunity to invest for greater growth, or to restore portfolio balance.

The same survey found that advised investors with a good understanding of risk tend to invest more — reason enough to talk to clients about the hidden risks that may be lurking in their portfolios. The survey also found that clients who understand risk are four times more likely to be happy with their advisers.

Patrick Nolan is a portfolio strategist at BlackRock’s Portfolio Solutions group.