Weathering Risk With All-Weather Portfolios

Weathering Risk With All-Weather Portfolios

Performance comparison of Different Assets and Portfolio

There are occasions when equities will perform better, there are times when debt will perform better and there are times when gold will outperform the other asset classes. The purpose of an all-weather portfolio is to manage the risk aspect as you create wealth in the long term

A majority of stock market investors are now nervous as well as confused about the short-term movement of the equity market. The recent run-up and a subsequent fall of the equity market from its high have indeed created chaos in the minds of equity market participants. Does it make sense to invest more at this point of time? This is the uppermost question in all discussions. There is doubt regarding the current momentum in the equity market. Concern around surging inflation that may become sticky rather than be transitory in nature is what has come to the fore. Higher inflation is seeping into the bond yields, which have started inching upwards.

This has resulted into making investment into long duration bond funds very unattractive. Most of the debt funds are generating returns in low single-digit and for some the returns are even lower than 5 per cent. Nonetheless, investment in commodities-related stocks has performed exceptionally well in the last one year. For example, funds with the energy theme have been the best performing and generated 88 per cent returns. In April 2020, due to the pandemic and expected lower demand along with a price war between two energy majors, Saudi Arabia and Russia, the oil prices sunk into the negative. This meant that oil producers were paying oil buyers to take the commodity. What all this means is that the future is unpredictable.

The current macro-economic situation is diametrically opposite to what happened 18 months back. There was concern about growth in economy and falling inflation. Both these factors have subsided now and inflation and growth are back with a ven-geance. For an investor, such a fast-changing situation makes investment very tricky. It’s advisable to be prepared for anything – inflation, deflation, rising economic growth or slowing economic growth. Markets react to surprises since they work on a cause-effect principle. Most of these cause-effects are built on expectation of the future rather than reality. So, if you look at any security – whether bonds, stocks, commodity or currency – the price change is due to change in expectations of the future which are dependent on a whole range of stimuli.

That is where diversification comes in handy. The key to creating an all-weather portfolio is to diversify your risk across a variety of asset classes so as to be able to play across a greater span of economic possibilities. Hence, invest in assets that have lower correlation between them or even better, negative correlation. A commodity such as gold has very low and negative correlation during the equity market downturn. Hence, by including gold it is possible to ride the uptrend, spread the risk of the portfolio and also reduce your exposure risk to the regular asset classes such as equity and debt. One can invest in gold digitally. This diversified portfolio should be re-balanced once in a year at least.

All-Weather Portfolio
Building a portfolio based on the above premises will help your portfolio to weather all the conditions. Ray Dalio, founder of Bridgewater Associates, a leading hedge fund with USD 160 billion in asset under management, pioneered an investment portfolio that would perform well across all environments and can handle all surprises. The all-weather portfolio dates back to 1996. It was the product of analysis by Bridgewater Associate’s Bob Prince and Ray Dalio, among others. What they found is that economic cycles revolve around two things, namely, inflation (deflation) and growth (contraction). As growth and inflation rise and fall, different asset classes either rise or fall. The goal of the all-weather portfolio was to gain exposure in roughly equal percentages of the various asset classes that perform well in each quadrant (In terms of risk contributed towards portfolio). At Bridgewater Associates, the result was the following:

The above matrix shows different assets, how they perform during different market expectations and how they exceed in terms of growth and inflation. For example, during rising inflation and rising growth, floating rate bonds and commodi-ties perform well. Similarly, with falling inflation and falling growth, long-term bonds do well.

Performance Matters
Based on the above theoretical background, we built a portfolio and compared it with individual asset classes. The period of study was between 2007 and October 2021. Even while building an all-weather portfolio we took different two different weight-ages. One is equal weightage and the second has higher weightage – 60 per cent to equity, 25 per cent to debt, 10 per cent to floating rate fund and 5 per cent to gold. Portfolios are rebalanced annually at the start of the year. The following table gives you a glimpse of risk and return statistics of different asset classes and a portfolio built with these asset classes with different weightages.

The above table clearly shows that the best annualised return is generated by a portfolio with higher weightage to equity. It is even better than pure equity fund. Although the first portfolio with higher weightage has generated better return, in terms of risk measured through standard deviation and maximum drawdown it has not performed well. The chart below shows the cumulative performance of all the asset classes and portfolios. It is visible that gold has performed well in turbulent times and remains one of the best performers. Nevertheless, gold also has a larger drawdown and is not a consistent performer.

The purpose of an all-weather portfolio is to manage the risk factor as you create wealth in the long term. There are occasions when equities will perform better, there are times when debt will perform better and there are times when gold will outperform the other asset classes. What this means is that over a period of time as cycles get evened out, the all-weather portfolio does better than the index by a margin. But, more importantly, it is a portfolio that has a lower drawdown than a pure equity portfolio. The portfolio that we built above is not fit for all and hence you need to get your asset class mix right that suits your risk profile. So if you are risk-averse you can invest more in long-term bonds or floating rate funds.

Secondly, you need to adopt a more dynamic approach to asset allocation. And finally, the phased approach always works best in volatile markets. An all-weather portfolio is designed to generate higher alpha by keeping the beta low.

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