The following article by Stuart Fowler was published in Citywire.  He suggests the extraordinary polarisation of opinions about future inflation should make it obvious that bonds, or conventional fixed interest investments, are not suitable for their role in ‘balanced management’ throughout private wealth management, where they are the main means of varying portfolios by personal risk tolerance. Wrong risk, wrong risk-management solution.

Left for deflation, right for inflation. If this describes well the directional options open to bond holders, as the current debate raging between bond bulls and bond bears implies, it carries an awkward message for ‘balanced management’. Conventional portfolio diversification relies heavily on the volatility-smoothing characteristic of nominal debt instruments. This characteristic in turn relies on the fact that, in most business cycles, long-term interest rates are weakly or even negatively correlated with equity returns because of cyclical leads and lags. As a form of risk control, the substitution of equity and property exposures by bonds collapses if the changes in inflation are much greater than can be explained by a normal business cycle. In that case, the volatility-smoothing benefits may still obtain but at the expense of a far greater impact on real wealth levels. The business cycle risk implicit in equities is only reduced by exchanging it for a bet on unknown future inflation. Since for most private investors this trade off reduces utility (or expected benefit), it should be clear that balanced management is fundamentally flawed as the main means of risk control in wealth management.

In the table below the role of bond holdings stands out, being the main differentiator between each of three levels of risk tolerance captured by design in the construction of the APCIMS benchmark indices for private client portfolios. Do not be confused by the word ‘income’ appearing in one title as this corresponds closely to the cautious end of the risk spectrum, on the basis of the normal return-smoothing affect of bond holdings.  Likewise, do not be confused by the addition of hedge funds in the other two, as their return paths can be fairly closely matched by some mix of equities and bonds. Balanced management, as a form of risk control, is all about bonds.

For UK bond holders, and for many other investors elsewhere in the world, inflation risk dominated business cycle risks for most of the period from the 1950s to the late 1980s. It dominated again in the 1990s as persistent errors  in underestimating inflation were replaced by errors in the direction of overestimating inflation. Since risky assets exposed to business-cycle risk have historically dealt tolerably well with inflation risk over long periods of investing, most UK private clients could be forgiven for wondering why their personal risk tolerance is usually matched to an asset allocation mainly by the weight in an asset so prone to cumulative estimation error and which they could easily live without.

Ten-year gilt yields of 2.9% are broadly equivalent to levels which in the past were associated with an expected inflation rate of zero. Either this is what the average investor thinks will now happen or, more likely, actual opinions reflect the debate and are divided between those expecting a Japan-style drift down in price levels and those expecting a return to high and unstable inflation, as the price to pay for minimising the greater evil of a depression in the real economy.

It is simply not reasonable to expect private clients to have much confidence in their own opinion as to which of these alternatives is the right forecast. But neither is it reasonable, hard as we may plead one case or the other, to expect them to trust our opinion as professionals. Truth is, most investors do not want to make either form of the bet. To avoid making it, they may have to opt out of balanced management.   

They do have an alternative but not many wealth managers currently offer it. If they were institutional investors, like UK pension sponsors, they could join the near 50% of their community and opt for a Liability Driven Investment (LDI) approach, working with a consultant to determine the nature, quantum and time horizons of their future money needs before event starting to discuss a portfolio solution. Each attribute of the need can be matched by an asset with the same characteristics, in other words a ‘hedge’. Hedging is an expensive luxury and without great wealth can condemn a saver to a mediocre future  so there is an incentive to create a budget for risk taking, or deliberate mismatching of part of the needs, that offers upside risk even if it opens up some chance of a worse than mediocre outcome. Both institutions and individuals are used to thinking in terms of budgets, insuring, risk taking and doing so by reference to consequences so all three elements of LDI are far more intuitive and relevant than the industry’s theoretical investment solution.

For most private clients, the nature of their money needs is characterised by inflation exposure, as they often relate to spending many years in the future. That is why we can safely assume that informed individuals would not plan to take on cumulative long-term inflation risk as part of their risk budget in order to reduce the path volatility arising from business risks, as in equities and property. After all , their earlier needs for money can be fully matched by hedges if they choose, so their response to volatility is anyway unlikely to remain unchanged after adopting an LDI approach.

In an LDI plan where inflation bets have been excluded from the risk budget, portfolios are separated into two components: hedges (cash for short-term needs and index linked gilts for horizons exposed to inflation risk) and globally-diversified equities. The second could include UK or foreign property although most UK investors already have high exposure to owner-occupied property. There is neither room for, nor need of, conventional bonds expressed in money terms in either the risk free or risky component. Investors opting into LDI can afford to stay detached as the pundits argue the life out of whether bonds are a bubble or the best investment going.

TAGS: Active management, asset allocation, bonds, inflation, LDI