By Nic Spicer, UK head of investments at PortfolioMetrix
2022 was an unprecedented year for many reasons. Many of us will remember it for the shocking invasion of Ukraine as well as rampant inflation. For those of us working in financial advice and investments, we will also remember it as a year equities and bonds ceased to act in partnership as they typically do.
Equities – with a few exceptions, such as commodity producers – suffered through 2022 while in many cases, shockingly, bonds actually fared worse than shares. That all-important negative correlation between equities and bonds that the asset management industry relies upon went AWOL – nowhere to be seen.
This represented a challenge for all multi-asset fund managers because the primary diversifier to equities did not do its job properly – or, in fact, at all. Equities and bonds sinking hand-in-hand created an unusual period for those multi-asset managers who chase outright performance. It made it tougher still for multi-asset managers and discretionary fund managers who create risk-rated ranges – for example, those that run on a scale from 1 to 5, 1 to 7 or from ‘cautious’ through to ‘adventurous’.
‘Cautious’ to ‘balanced’ portfolios in the UK – typically weighted heavily to UK bonds or global bonds hedged back to sterling – fared particularly poorly across the market as they rely on bonds to reduce volatility when equities go south. On the other hand, some of the more aggressive and adventurous portfolios were less volatile. In a year the pound fell dramatically against the dollar, their greater weighting towards equities gave them a greater weighting to the latter – the world’s main trading currency – which cushioned falls. Overall, it was a very unusual year.
This unpredictability led to what we refer to as ‘spaghetti-like’ returns. Instead of a nice straight, diagonal line on the returns/risk scale – from the most cautious portfolio (low risk/low returns) through to the most adventurous (high risk/high returns), 2022’s graph looked a bit like a wiggly piece of pasta. A lot of investment managers struggle to keep their graphs as straight as can be in ‘normal’ times, but the unpredictability of 2022 saw more pasta-like charts than usual.
For our part, while our line was not perfect in 2022, we do not think we did too badly. It was not the straight, diagonal line we aim for – in truth, it was more of a banana shape, actually – but crucially it did not detract from our pleasing longer-term diagonals. Precise, rather than pasta, is our aim – and what we have still achieved over the long term.
Inflation and uncertainty
It is said that diversification is the only free lunch in investments – and I would certainly subscribe to that notion. During periods such as we saw in 2022, when core correlations shift, it is one of the few things we investment managers can rely on.
By that, however, I mean real diversification – not just between equities and bonds, but across many different investment sub-types too. It is fundamental to ensure clients are never over-concentrated in any sub-asset class, industry, country, currency, factor, fund or individual security.
Using our own portfolios as an example, them, what did we do? For direct inflation protection, we added Royal London Short Duration Global Index Linked in our lower and medium-risk portfolios and increased weighting to real assets (mostly listed infrastructure, an asset class we had added to portfolios in late 2019) throughout our ranges. For recession protection we added Vanguard US Government Bond Index Fund (after it had already fallen 9% over the first half of the year) and increased US equity allocations after the sell-offs that continued until May.
Reacting to markets in isolation does not work too well, however – you must also think and plan ahead. When it comes to time horizons, we would much rather think in financial planning terms. Portfolios need to go the distance of a wealth manager/client relationship, rather than be assessed according to subscriptive, short-term periods.
In 2022 we did not have any dedicated UK government gilts or UK inflation linkers given their very low yields at the beginning of the year but very high durations – for which read interest rate risk. This was very helpful during the UK’s brief flirtation with disastrous Trussonomics last autumn. In general, our bond exposure was also lower duration than broad indices, which was helpful in 2022. Helpful too was raising our US equity exposure in late 2021 to add more dollars into the portfolio, given how strong the currency was during the year.
Our actions followed our usual three key steps for periods of market turmoil – or ‘ABC’. ‘Assess’ – which is to say we do not ignore the short-term but maintain our long-term focus. ‘Be proactive’ – prepare in advance, act now if necessary and plan for the future. And crucially we ‘Communicated’ extensively, answering client questions and reassuring.
Looking ahead, managers should be in for an easier time for the rest of 2023 than in 2022. While it is unlikely to be completely smooth sailing, and inflation and interest rates are still likely to drive markets, equities and bonds started the year more reasonably priced than the beginning of 2022 when prices were sky-high. Most notably, bonds have far more generous yields than they did before Russia’s invasion of Ukraine.
