BofA Merrill Lynch recently put out a note highlighting that interest rates have fallen to a 5,000 year low. Quite how they have computed this and precisely what the practical implications it has are not clear but I think the gist of their message is self evident.
Without any enthusiasm, we persisted in holding gilts in our portfolios until exiting all our positions during the first few days of autumn. We concur with the consensus that bonds on low yields are lousy investments but we had maintained the view that gilts remain an essential part of our portfolio construction. Few, if any other, assets complement risk assets, such as equities and credit, like sovereign bonds.
However, with many gilt issues trading on sub 1% yields it is difficult to see them as being capable of buttressing portfolios during any risk off episodes. This has left us looking for alternative instruments to diversify our portfolios. Alternative approaches to portfolio construction do exist but unfortunately they do have their limitations:
a) Put options. Ignoring the practical problems of strategy implementation in the retail market, this approach has been well tested and found wanting. Index put options are sadly structurally overpriced and portfolio insulation typically costs around 1% p.a. With such a negative carry, gilts appear to be a positive bargain.
b) Liquid alternatives. Introducing complex hedge fund strategies for retail clients is a stretch, but more than that, we have seen time and time again that the average hedge fund fails to withstand broad market sell offs. True there are exceptions. CTAs have proved themselves to be uncorrelated, as have market neutral long short funds. Unfortunately, CTAs are way too complex for our client base (and for me for that matter) and good market neutral funds are as common as he's teeth. By and large you would have to pay up for quality managers and this would be a major issue for our client base.
c) Commodities. In theory, traded commodities could add diversification but many of the major lines such as energy and industrial metals are tied to the economic cycle. Agricultural commodities on paper may suit but the sector is coming out of the brief bull phase of its 45-50 year cycle. That said, research highlights that much of the long term returns have come from the roll yield. A brief review of Bloomberg reveals that many of the major commodities have steep curves. This could present opportunities. Funds focused on commodities are hard to find, especially retail ones but it might be worth making some effort here. Interestingly, GMO are currently making the case for commodities.
d) Gold. Philosophically gold troubles me. It is dug out of the ground at enormous expense, shipped half way around the world only to be buried in an elaborate vault somewhere deep within a bank. It makes no sense. That said gold does have a certain biblical creditability, it does trade in an idiosyncratic manner and is enormously volatile. A limited exposure might be useful, if you can swallow the concept.
e) Cash, will act as a volatility stabiliser albeit rarely as potent as bonds. Reductions in bond exposure may require a reduction in equities to maintain a constant risk profile. However, high cash exposure might lead to some interesting discussions with clients, especially if the allocation persisted for years.
Abandoning government bonds in balanced portfolios is far from a straightforward task.
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