Risky business

Even in the midst of a bull market it's important to protect your portfolio – just in case there's a bear lurking around the corner

Portfolios have generally performed well since the global financial crisis, but as we all know, markets are notoriously unpredictable. Which is why it's important to think about downside protection throughout the entire economic cycle. However, achieving this through traditional asset allocation is becoming more difficult.

Thanks to the global financial crisis and the subsequent zero interest rate policy, the behaviour of asset classes has changed. Government bonds (gilts) and equities used to be negatively correlated (tending to move in opposite directions); now they are much more closely correlated. Gilts are therefore no longer attractive as downside protection – they are also very expensive. Historically, gilts also had the benefit of paying an income that offset risk. Investors were getting yields in the region of 4-5%, which helped offset any downturns in the market. Now that gilt yields are down to 1.26% over 10 years 1, this strategy no longer makes a great deal of sense. And if we look at volatility over a one-year period, the gilt market has proved more volatile than the FTSE All Share Index. In the past 12 months UK Government Bonds returned 0.86%, and for much of the last year, gilt volatility has been higher than UK equity volatility2.

The issues around gilts are particularly salient to private investors, as there has been a democratisation of financial risk. As pensions shift from Defined Benefit to Defined Contribution schemes, more people are taking responsibility for managing their own pension investments. But as many don't fully understand the composition of their portfolios, our concern is that the natural inclination to protect the downside with government gilts is increasing portfolio risk.

Some investment managers are addressing the issue by bringing alternative assets into the investment solution, for example infrastructure funds and renewable energy funds, all of which offer higher starting yields of 5-6%. But there is inherent risk within those structures and to some extent they are correlated with what's happening to gilts in the fixed-income market.

An alternative approach would be to construct a portfolio that includes non-correlated assets that protect a portfolio from downside risk, but also offer potential returns over the longer term. This involves diversifying the portfolio away from traditional asset classes and bringing in some institutional investment techniques that utilise currencies, credit instruments, infrastructure and derivative strategies.

Standard Life Wealth has a distinct investment philosophy that focuses on change. We embrace the ever-changing market environment and the needs of our clients, and are continually looking for innovative ways to deliver strong, robust returns.

The value of investments can fall as well as rise and you may get back less than you invested. Past performance is not a guide to future performance.

  1. 30 June 2017
  2. UK Conventional Gilts All Stocks Index, as at 30 June 2017

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