In the past, the choice to maintain an investment portfolio of 60% equities and 40% bonds was a prudent one. This distribution, which allowed for diversification between these two types of assets, has long been the standard.

But today, with inflation at 40-year highs and volatility seemingly here to stay, this once-prudent approach to investment may fall short. How can investors offset this? Enter alternative hedging strategies.

Why 60/40 doesn’t work today

In the past 30 years, bond yields have been declining while equity returns have been strong. Since bonds are negatively correlated to equities, “balanced” 60/40 portfolios have been able to experience both strong returns and reduced volatility.

This is because, with a 60/40 approach, when you’re trading positions to get back to those target weights of 60/40, you’re selling the assets that have outperformed and buying the assets that have underperformed. So when both asset classes are moving higher over time, this rebalancing process helps long-term portfolio performance.

But this approach may not hold up in today’s market environment. Now, inflation is much higher than it’s been in recent memory, and, as a result, the correlation between stocks and bonds has fundamentally changed. That negative correlation that produced such favorable results in the past has given way to a positive correlation, resulting in portfolios with lower returns and much higher volatility (Chart 1).

Chart 1: Positive correlation, negative impacts on portfolio performance

 Source: Bloomberg, abrdn, June 2022.

Why does volatility matter if you’re a long-term investor?

What’s commonly referred to as the “volatility drag” that affects portfolio returns during periods of market uncertainty is the difference between geometric compound returns and arithmetic mean returns.

Arithmetic mean return: If a portfolio is down 50% one year and up 50% the next, it has a zero arithmetic mean return (the average of -50 and +50).

Geometric compound returns: In the same scenario, the geometric return is -25%. This is because if this hypothetical portfolio started at 100% and declined by 50%, it would sink to 50% in that first year. If, the next year, it rose 50% from this point, 50% of 50 is 25, so now we’re up to 75% — 25% less than where we started at the beginning.

The difference between these two perspectives on return underlines just how deeply drawdowns can scar a portfolio. After a significant loss, it’s harder to compound returns over the long term.

Since volatility has persisted for several months now and the traditional 60/40 portfolio may be faltering, it may be time to consider a different approach to portfolio construction.

Introducing alternative hedging strategies

Incorporating an alternative hedging strategy could be one solution to the problems plaguing today’s investment portfolios. One way to incorporate this type of strategy could be to employ a diversified portfolio of alternative strategies with low correlation to equities. Something like this could help investors make up for some of the diversification potential they’ve lost as equities and fixed income have become more positively correlated.

Hedging strategies can add positive convexity to a portfolio. This means that it has a return profile that tends to exhibit small losses relative to large gains. Positively convex strategies look something like an option where you pay a small premium, so if nothing happens, you lose the small premium, but if the market moves your way, you can potentially make a large gain.

This type of strategy ultimately seeks to minimise downside volatility in a portfolio and thereby help to generate attractive compound returns.

This type of strategy ultimately seeks to minimise downside volatility in a portfolio and thereby help to generate attractive compound returns. But it wouldn’t be a total replacement for the traditional portfolio. It’s meant to be used in combination with risk assets.

Traditional portfolio returns typically exhibit a negative skew during periods of market stress. When looking at the distribution of a portfolio’s returns, a negative skew indicates that an investor may expect more frequent smaller gains from the portfolio and less frequent but more severe losses. This results in a large volatility drag that materially reduces long-term returns.

Adding alternative hedging strategies with positive convexity can help correct this negative skew and reduce that volatility drag. The fundamental trade-off investors need to consider when looking at downside risk mitigation strategies, therefore, is whether the potential cost of holding the hedging component is more than offset by the gains from the reduced volatility drag in the portfolio (reducing the size of drawdowns).

Alternative hedging strategies aim to iron out 60/40 wrinkles

With this type of strategy, the goal is to minimise the impact of market drawdowns without sacrificing the potential for positive returns. Simply stated, effective hedging is meant to mitigate downside risks while still allowing investors to participate as much as possible in the upside.