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  • Guessing which assets will perform consistently well is notoriously difficult.
  • Bonds remain the best equity market diversifier.
  • Equities deliver better risk-adjusted return than commodities in an inflationary environment.

 

By Mohneet Dhir, multi-asset product specialist, Vanguard Europe

Rising headline inflation was already a concern for investors before Russia’s devastating invasion of Ukraine exacerbated global supply chain issues. Now, after global equity and bond markets posted negative returns in the first few months of 2022, investors might be tempted to look for other ways to boost returns.

It could be overweighting a certain region or sector, ‘going short’ on duration or even allocating to alternatives to outpace inflation. The truth is, though, that often the best course of action is to stay disciplined with a globally diversified portfolio of equities and bonds.

It might not sound as exciting or as appealing as more tactical approaches but all our experience and research points to broad market diversification being more effective when it comes to achieving long-term investment goals.

Mohneet Dhir, Multi-asset product specialist, Vanguard Europe

Our range of LifeStrategy funds are designed with broad diversification in mind. Using Vanguard index funds as the building blocks, they aim to allow investors to benefit from the better-performing investments each year while avoiding too much exposure to the worst performers.

Bonds remain the best equity market diversifier

Perhaps the first and most important type of diversification is that of equity market risk. Investing in equities is a great way to drive long-term returns, but stock markets are volatile and can lead to big swings in performance.  For the most part, bond markets offer a neat hedge against equity market downturns, owing to the broadly negative return correlation between the asset classes.

However, in the past 20 years, the return correlation between equities and bonds has tended to move into positive territory for short periods, before reverting back to a negative state if given enough time.

High inflation is one of the primary factors that can disrupt the negative relationship between stocks and bonds, but it needs to be sustained over a multi-year period. By our calculations, we would need to see annual core inflation in the US, for example, of around 5.7% over the next five years for this to become a risk in the near future, whereas we expect core inflation of about 4.9% in 2022 falling to 3.3% by end 2023.

The risk-reducing benefits of broad market diversification

As the chart below shows, it’s difficult to say exactly which investment within equity and bond markets will perform well from year to year. Although North American equities have outperformed the broader market in the past four years, history tells us that such a trend is rare and unlikely to persist.

Take European equities as an example, which was the top performer in 2012 and second-best performer in 2013, before falling to the bottom of the list with a negative return in 2014. A more recent example of the unpredictability of short-term asset class returns is UK equities, which has bounced back and forth from bottom of the pile to fourth- and third-best performer over the past four years.

Asset class returns can vary

Key bond and equity returns (%), ranked by performance with returns from LifeStrategy 60% Equity Fund

Past performance is not a reliable indicator of future results.
Source: Vanguard calculations as at 31 December 2021, using data from Barclays Capital, Thompson Reuters Datastream and FactSet. Global equities as the FTSE All World Index, North American equities as the FTSE World North America Index, Emerging market equities as the FTSE All-World Emerging Index, Developed Asia equities as the FTSE All World Developed Asia Pacific Index, European equities as the FTSE All World Europe ex-UK Index, UK equities is defined as the FTSE All Share Index, UK government bonds as Bloomberg Sterling Gilt Index, UK index-linked gilts as Bloomberg UK Govt Inflation-Linked UK Index, UK investment grade corporate bonds as Bloomberg Sterling Aggregate Non-Gilts – Corporate Index, Hedged global bonds as Bloomberg Global Aggregate Index (hedged in GBP). Performance shown is cumulative and denominated in GBP. It includes the investment of all dividends and any capital gains distributions. The performance data does not take account of the commissions and costs incurred in the issue and redemption of shares. Basis of fund performance NAV to NAV.

In contrast, the white blocks in the chart represent the returns of the LifeStrategy 60% Equity Fund, which offers investors exposure to more than 10 countries, 11 equity sectors and high-quality corporate bonds rated from AAA/Aaa to BBB-/Baa3 – more than 27,000 unique equity and fixed income holdings.

As we’d expect, given the portfolio’s spread across global investment markets and 40% weighting to global bond markets, the fund generally delivered an average return each year relative to the wider market. So, it’s clear that broad diversification can help investors navigate the short-term uncertainty of different markets and eliminate the risk of putting all your eggs in the wrong basket, so to speak.

Doesn’t high inflation mean it’s better to be ‘short’ on duration?

Rising headline inflation is always a concern for bond investors. That’s because high inflation often leads to interest rate hikes. As the market prices in higher future interest rates, the prices of long-duration bonds are dragged down as the original coupon payment looks less attractive.

This is a topic I covered in a previous blog but given the circumstances it’s a point worth reiterating. Taking tactical positions with your fixed income exposure, like ‘going short’ on duration (i.e., switching to less rate-sensitive bonds often with shorter maturities, before switching back), means changing the overall risk profile of your portfolio. The success of this approach depends on predicting future bank rate movements before the market and shifting your allocation accordingly.

Bonds are there to offer stability against the volatility of equity markets, not to drive returns. That’s why LifeStrategy funds don’t take tactical positions in fixed income (nor equities, for that matter). The funds maintain a diversified exposure across the investment-grade debt universe, including government bonds and high-quality corporate debt across a range of maturities. That includes inflation-linked gilts, which bring an average maturity of 21 years to the portfolios, but also a natural inflation hedge to the funds through inflation-adjusted interest payments and principal payment (repayment at maturity).

What about alternatives?

Some investors have asked about the credibility of allocating to alternative asset classes as a means of hedging against rising inflation. Our research found that while gold and commodities offered a better hedge in the short-term (one year) against inflation relative to equities, it came at a price – far higher volatility1. So, while these investments might outpace inflation – at least initially – they come with increased risk. Over longer-term horizons of five, 10 and 20 years, equities provided the greatest chance of achieving a positive real return with a lower level of risk relative to gold and commodities more broadly2. That means long-term investors who are worried about the corrosive effect of inflation might want to consider a portfolio with a greater exposure to equities.

All-weather portfolios

Without a crystal ball, broad diversification makes sense for most investors. Trying to pick and time investments tactically increases risk and requires more time, effort and, ultimately, luck to get it right. And getting it right all the time is nigh on impossible.

By maintaining broad diversification across investment markets, LifeStrategy funds are designed to deliver value to investors under all market conditions.

 

1 Source: Vanguard calculations, based on data from Bloomberg and the OECD. Notes: Analysis of the short-term beta to UK inflation and volatility of different sub-asset classes. Volatility is calculated as the standard deviation of rolling one-year annualised returns, at monthly frequency. Inflation beta is defined as how much an asset's return increases when inflation goes up by 1 percentage point. The sample period is 31 January 1972 to 31 October 2021.

2 Source: Vanguard calculations, based on data from Bloomberg and the OECD. Notes: Analysis of the proportion of real five-, 10- and 20-year returns that have been above 0% for global equities, UK equities, gold and commodities. The sample period for the monthly data is 31 January 1975 to 31 October 2021. Volatility is calculated over monthly returns of the entire sample period. Indices used: global equities = MSCI World Net Total Return Index; UK equities = MSCI UK Net Total Return Index; commodities = S&P GSCI Index Spot; gold = Gold Spot.

Investment risk information

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Some funds invest in emerging markets which can be more volatile than more established markets. As a result, the value of your investment may rise or fall.

Investments in smaller companies may be more volatile than investments in well-established blue chip companies.

The Vanguard LifeStrategy® Funds may invest in Exchange Traded Fund (ETF) shares. ETF shares can be bought or sold only through a broker. Investing in ETFs entails stockbroker commission and a bid- offer spread which should be considered fully before investing.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

The Funds may use derivatives in order to reduce risk or cost and/or generate extra income or growth. The use of derivatives could increase or reduce exposure to underlying assets and result in greater fluctuations of the Fund's net asset value. A derivative is a financial contract whose value is based on the value of a financial asset (such as a share, bond, or currency) or a market index.

For further information on risks please see the “Risk Factors” section of the prospectus on our website at https://global.vanguard.com.

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