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November 18, 2020 | GSAM Connect

Portfolio Diversifiers: How Did They Hold Up?

Today’s low rates and high equity valuations have sparked a lively dialogue among investors about developed-market investment grade debt. Is it, many wonder, still an effective hedge against equity risk? Or might other asset classes do a better job?

Many assets that investors typically use to hedge risk were put to the test when the pandemic hit in March. And performance suggests that developed investment grade bonds—the anchor of a core fixed income allocation—passed.

Let’s take a look at what happened. Global equities, as approximated by the MSCI World Index, dropped 13.2% in March. That was their fourth worst monthly performance on record, trailing October 2008 (the Global Financial Crisis), October 1987 (Black Monday) and August 1998 (the Russian Ruble Crisis). But as Exhibit 1 shows, government bonds in the US and UK held up well (though German Bunds were down 0.5%).

EXHIBIT 1: Performance of traditional and non-traditional perceived portfolio hedges in March 2020

Source: Goldman Sachs Asset Management, Bloomberg. As of 3 April 2020. For illustrative purposes only. Past performance does not guarantee future results, which may vary.

What about other traditional equity hedges? Gold was up just 0.8% in March, likely disappointing many who had relied on it to outperform in periods of market stress. And it wasn’t just gold that struggled. Precious metals more broadly were down 1.4% on the month, while the Japanese yen and Swiss Franc—two currencies that often do well during market pullbacks—were roughly flat. Catastrophe bonds were down 1.8%, while absolute return strategies known as alternative risk premia were down 6%. Cryptocurrencies, speculated to act as an uncorrelated “safe haven” asset class but never previously tested, disappointed, with Bitcoin down 25.7% and Ethereum down 41.5%.

For the purposes of this exercise, we did not include illiquid investments such as property funds, which were mostly gated. After all, a hedge is less valuable if you cannot use it to rebalance into lower equity valuations or cash out if needed.

How should we evaluate the performance of these portfolio diversifiers in the worst month in more than a decade? In our view, a key takeaway is that developed-market, investment grade government bonds performed largely in line with investor expectations, with longer duration fixed income hedging more effectively than shorter duration.

For investors more reticent to hold long duration bonds in their portfolios, trend following strategies were one of the few places to hide. That’s not an anomaly. During the 2008 Global Financial Crisis, trend-following strategies were up during the worst of the equity and real estate drawdowns.

For some investors, it may make sense to complement core bonds with an allocation to absolute return strategies that emphasize trend following. These may provide downside risk benefits without the duration risk of bonds. And with the massive amounts of new government debt being issued, trend following strategies may continue to provide a counterbalance alongside government bonds if we see periods of higher inflation in the future.

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