At the risk of meandering this thread in yet another direction: one issue that seems critical is the sensitivity of the portfolio risk to the stock-bond correlation going positive. Portfolio volatility is a function of asset volatility and the correlation between assets, portfolio max-drawdown is a function of asset large drawdowns and their propensity to co-occur. So an increase in stock-bond correlation implies an increase in the riskiness of the portfolio.
My thinking is that since the correlation is dynamic (varies over time), we should evaluate the maximum risk of the portfolio depending on the maximum plausible correlation (i.e., positive), not the recent (negative) or average (zero) correlation. So if we construct the portfolio by maximizing Sharpe then leveraging to a desired maximum risk, correlation is relevant to both steps (higher correlation -> lower Sharpe; higher max correlation -> lower leverage and hence lower returns).
Correlations are standardized measures of co-movement. The best conceptual framework I am aware of to explain short-term (co)movements in investments are the macro factors of growth and inflation expectations (and volatility of growth and inflation expectations). Changes in inflation expectations move stock and bond prices in the same direction so the stock-bond correlation will increase in times of inflation uncertainty and volatility. In this framework we can see that stock-bond portfolios are optimal for the recent past (low growth, low inflation, low volatility), but not for other periods (e.g., high inflation volatility of the 1970s).
Modifications to a stock-bond portfolio to reduce the average and maximum stock-bond correlation or off-set this covariance can be categorized as three types:
First, reduce the sensitivity of the stock part to inflation expectations (i.e., reduce disinflation beta):
- Global diversification (not US-only). This should help to the extent inflation is not perfectly positively correlated across countries.
- Small-value tilt. Value is a) slightly more pro-inflationary vs growth (at least, it overweighs pro-inflation sectors like energy); b) shorter duration so less embedded rate sensitivity; and c) to the extent value risk reflects greater economic growth risk, this is "good" risk because it can be hedged with bonds (in contrast to inflation risk).
- EM tilt. EM may do better with high inflation (commodity exporters), and high growth (which is relevant to the extent high growth co-occurs with high inflation). This effect may be stronger if EM stocks are not currency-hedged back to USD due to the EM currency exposure.
Second, reduce the sensitivity of the bond part to inflation expectations. To the extent bond yields reflect growth and inflation expectations, nominal bonds have an embedded short position on inflation. Certainly back tests show bonds are very negatively affected by unexpected inflation and more than stocks.
- Tilt shorter duration. See this graph from the book Expected Returns.
- Tilt inflation-linked. Kind of obvious: reduce inflation sensitivity by removing the embedded short inflation position in nominal bonds by replacing them with TIPS. Unfortunately there are less ways to access TIPS than nominal treasuries. Leveraging ITT TIPS ETFs with options or margin is expensive. Long duration TIPS with LTPZ may be better, but ER is a little high (.20%). Note the play here is borrowing at nominal rates to invest in something that moves with inflation; inflation inflates away the debt while the asset maintains real value.
- Global diversification. I'd like to do this but managing futures in different currencies and exchanges seems difficult and maybe inefficient. Australian bonds are a good choice (AAA rated, commodity currency -> positive inflation exposure, Australian housing bubble may imply a limit on how high Australian rates can go).
- EM bonds. We have three flavors: EM USD-denominated; EM local currency denominated, currency hedged; EM local currency denominated, currency unhedged. The third is probably the most effective inflation hedge. Great in theory but has a large downside relative to upside (i.e., they crash hard). Also a little expensive (my preferred ETF, LEMB, has ER = .30%). Note EM bonds effectively have EM equity exposure so contribute to stock exposure too.
- Underweight bonds. This seems to be the approach a lot of people take after observing the challenge with inflation in back tests.
Third, add an asset that moves positively with inflation expectations to counteract negative inflation exposure in stocks and bonds. Let's call them "alts". These are way too complex to summarize or evaluate concisely, but just to note those that seem more promising:
- Commodities. According to some, an inflation hedge with positive risk premium. Kind of "too good to be true" but the third leg in many risk-parity portfolios.
- Trend following/time series momentum. Maybe another risk factor (providing general diversification benefits) with "crisis alpha".
- Gold. Maybe the "flee the monetary system asset" during periods of inflation uncertainty.
- EM currency/currency carry trade. There is a premium in investing in EM/high interest rate currencies, but there should not be one under no arbitrage and the trade tends to aggressively reverse during stock market crashes. AUD, CAD, NZD, KRW could be relevant here too, and other currencies besides USD on the short side of the trade.
- I-bonds. I-bonds move with CPI and provide a positive return with very little risk (funded with box spreads). See recent posts in this thread.
- Real estate.
It might not be a good idea to completely neutralize your portfolio to inflation, especially for young people. First, being modestly short inflation helps hedge against deflationary crashes. Much of the hedging capabilities of nominal bonds exhibited in back tests is actually coming from being short inflation during a deflationary shock (in addition to being short real rates and nominal treasuries being "the safe asset"). A portfolio less negatively affected by inflation would probably have crashed harder in the GFC because it would be less positively affected by deflation. Second, having a modestly short-inflation portfolio balances a long-inflation human capital. I invest partly to hedge against governments and central banks continuing to kick the can down the road towards Japanification, lower real rates and capital over labor that would reduce opportunities to make money. If some type of inflation and growth spurt knocks us off that path, there could be other opportunities and human capital could be worth more. But I will tilt my portfolio towards disinflation in case, as most likely will be the case, we continue along the current disinflationary road to even lower real rates.
Looking at what the professionals do, AQR's
multi-asset fund seems the most transparent. They overweight (global developed) stocks over bonds (43% of risk allocation versus 23.5% of nominal bonds), assign just 4.4% to global inflation-linked bonds, 22.3% to commodities, and 6.6% to EM currency with forward contracts. Gold seems to be treated just like any other commodity and EM debt and equity is not present. Bridgewater is less transparent, but also have commodities. In contrast to AQR, Bridgewater seem to put more emphasis on inflation-linked bonds, gold, EM debt, and EM equity (at least China).
My stocks are globally diversified, small-value tilt (especially in US), slight EM overweight. Almost all my bonds are US treasuries except a small amount in EM bonds. I don't have separate currency positions but I don't currency hedge; carry trade seems fair so I don't want to pay to try to be on one or the other side of it and let my stock and bond allocations decide my currency positions. I've considered taking about a third of my bond risk in TIPS but I would not take more to avoid neutralizing the portfolio to inflation or making it positively related to inflation. I-bonds is by far the best alt but is limited by amount and cannot be used as collateral in your brokerage account. I am reluctant with the risk premium story for commodities, trend following, and gold, and think readily available funds for the first two are poorly constructed or too expensive. I think it would be useful to have at least some commodities (maybe 5-10%... not 20% of risk) but I am still looking for a good fund. Ultimately I think reasonable tilts in the stock-bond portfolio plus I-bonds should be the first step, and to the extent more protection is required, replacing some nominal treasuries with TIPS is the next step. Some alts (commodities in particular) could make sense but I do not have the conviction to dedicate more than a little risk to them especially when they cannot be accessed cheaply.
Thoughts/comments/criticisms? Any asset I have missed or something I overlooked?