By Mohneet Dhir, multi-asset product specialist, Vanguard Europe
- Bonds remain an effective diversifier to equity market volatility.
- Higher starting interest rates means the long-term return outlook for bond market has improved.
- Research suggests equities offer the best long-term risk-adjusted hedge against inflation.
There’s no hiding from it – it’s been a tough year for multi-asset investors with global equities and bonds falling in tandem over the course of 20221. Inevitably, this has fuelled questions around the role of a traditional balanced portfolio of shares and bonds and given rise to a number of ‘myths’ around multi-asset investing.
To help keep investors stay focused on their long-term plans amid the volatility, we debunk some of those myths and highlight the benefits of a long-term balanced approach to investing.
Myth 1: Bonds no longer provide sufficient diversification from equity markets.
Global bonds had a bad year. In fact, it’s been the worst year for global bond returns since the Bloomberg Global Aggregate Bond Index began in 19902 – and by some distance.
For long-term multi-asset investors, the primary benefit of bonds in a well-diversified portfolio is to provide a buffer against equity market volatility. It’s little surprise, then, that some have questioned the role of bonds in a diversified portfolio, given the fall in both equity and bond markets this year.
Our research suggests concurrent drops in equity and bond markets are not that unusual. As the chart below shows, viewed monthly since 1995, global equities and investment-grade bonds have been negative around 13% of the time. That’s a month of joint declines a little over every seven months or so, on average.
Extend the time horizon, however, and joint declines have struck less frequently because in the period covered investors never encountered a three-year span of losses in both asset classes (and barely encountered it over a one-year period).
Historically, stock-bond diversification recovers within a few months
Past performance is no guarantee of future returns.
Source: Vanguard. Notes: Data reflect rolling period total returns for the periods shown and are based on underlying monthly total returns, with dividends and income re-invested, for the period February 1999 to May 2022. Global shares are represented by the FTSE All-World Index and global bonds are represented by the hedged Bloomberg Global Aggregate Index. Returns are in EUR.
In short, despite recent declines, we still believe bonds remain the best asset class to act as a counterweight to equities. – In addition, bonds have historically provided a buffer against the recessionary sell-offs that occur in riskier assets during periods of slowing economic growth.
Myth 2: Rising rates are bad for bond investors.
While rising rate expectations might push bond prices down, Vanguard analysis suggests that a core allocation to global hedged bonds has served multi-asset investors well when interest rates rise quickly. For example, when US rates rose 4.25 percentage points between June 2004 and July 2005, hedged global bonds were among the best risk dampeners3.
From a returns perspective, rising interest rates means higher future income payments from bond portfolios over the long-term – and our analysis found the long-term performance of bond investments has come mostly from income return, not price return, as the next chart shows.
Interest income drives bond total returns
Source: Bloomberg. Notes: Monthly data from 1 October 2000 to 31 March 2022. Bonds denominated in EUR are represented by the Bloomberg Germany Aggregate Bond Index in EUR. In the calculation we assume that all income from the bonds is reinvested. The performance data presented here represents past performance and is not a guarantee of future returns. The performance of an index is not an exact representation of any particular investment as investors cannot invest directly in an index.
So, with interest rates expected to remain high relative to the past 10 years or so, income returns from bond investments are likely to play an even greater role in multi-asset portfolios over the next decade. Higher starting interest rates have raised our long-term return expectations for the asset class relative to our forecasts at the start of the year.
In other words, it’s short-term pain for long-term gain. Even over shorter horizons, we think future rate hikes are priced into markets and that global bonds offer good value in the near-term. The message for multi-asset investors here, we think, is to maintain a long-term perspective, be patient and focus on the total return from their bond investments, not short-term price returns.
Myth 3: Investors can time the markets.
The recent turbulence in markets might tempt some investors to withdraw their investments temporarily until markets steady or begin to rebound. Our research and experience suggest otherwise – that timing the market is notoriously hard because the best and worst trading days often occur within days of each other.
For example, five of the best trading days of the past 40 years or so, as measured by the performance of the FTSE All Share Index, occurred either in the wake of the global financial crisis in 2008 or after the Covid-19 sell-off in 2020, during years of negative total returns, as the chart below shows.
The best and worst trading days often occur close together
Source: Vanguard calculations, based on data from Refinitiv using the Standard & Poor’s 500 Price Index. Data between 1 January 1980 and 31 January 2022. Returns calculated in USD without dividends reinvested.
Still, expectations for an economic recession in 2023 might convince some investors to hold back from markets and even withdraw to cash. One of the problems with this approach is that stock markets tend to begin to rebound during recessions4, not after, as they anticipate a return to economic and corporate earnings growth.
That’s why we think investors shouldn’t try to time the market because they run the risk of missing out on some of the best-performing trading days and any potential gains from a stock market recovery.
Myth 4: Alternatives offer a better hedge against inflation.
Rising inflation has been one of the key themes for investors in 2022. The high inflation environment has led to calls for investors to reallocate capital from equity markets to alternatives, like gold and commodities, as a means to hedge against the corrosive effects of inflation on portfolio returns.
Our research found that gold and commodities offered a better hedge in the short-term (one year) against inflation relative to equities, with inflation betas higher than 1 (a beta score of 1 means the asset moves, on average, in lockstep with inflation). However, allocating to gold and commodities as a hedge against short-term inflation comes at a price – far higher volatility5.
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 broadly, as the next chart shows. 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, depending on their tolerance for risk.
Proportion of long-term positive real returns for gold, commodities and equities
Past performance is not a reliable indicator of future results.
Sources: Vanguard calculations, based on data from Bloomberg and the OECD, as at 31 October 2021. Notes: Total returns calculated in EUR. The chart shows the proportion of real five-, 10- and 20-year returns that have been above 0%. 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; euro-area equities = MSCI EMU Net Total Return Index; commodities = S&P GSCI Index Spot; gold = Gold Spot.
Maintaining a long-term perspective
After a particularly difficult year for multi-asset investors, the temptation to change approach is understandable. Even the most accomplished athletes admit to moments of self-doubt during a run of bad form.
Invariably, though, the route to success is grounded in getting the fundamentals right. That means staying disciplined and maintaining a long-term perspective with a well-diversified portfolio commensurate with the client’s goals and preference for risk.
1 Vanguard calculations, based on data from Bloomberg and MSCI. Global equities represented by the MSCI All Country World Index (in EUR). Global bonds represented by the Bloomberg Global Aggregate Index (in USD). Data from 3 January 2022 to 30 June 2022.
2 Source: Bloomberg & Vanguard as at 26 September 2022. Notes: Bond performance derived from the Bloomberg Global Aggregate hedged in euros index from 1990 to 26 September 2022.
3 Source: Bloomberg, Vanguard. Data is for the period from 31 May 2004 to 31 Jul 2006 and in EUR. Benchmarks and indices used: US equities = S&P 500 Net Total Return Index, UK equities = FTSE All Share Net Total Return Index, Developed markets equities = MSCI World Net Total Return Index, Global markets equities = MSCI ACWI Net Total Return Index, Europe equities = MSCI Europe Net Total Return Index, Eurozone equities = MSCI EMU Net Total Return Index, Dev. Asia Pacific ex Japan equities = MSCI Pacific ex Japan Net Total Return Index, Japan equities = MSCI Japan Net Total Return Index, Emerging markets equities = MSCI Emerging Net Total Return Index, Developed markets small cap equities = MSCI World Small Cap Net Total Return Index, Global high dividend yield equities = MSCI ACWI High Dividend Yield Net Total Return Index, Global aggregate fixed income = Bloomberg Global-Aggregate Total Return Index Unhedged EUR, US government fixed income = Bloomberg US Treasury Total Return Index Unhedged EUR, US corporates fixed income = Bloomberg US Corporate Total Return Index Unhedged EUR, Euro government fixed income = Bloomberg Euro Aggregate Treasury Total Return Index Unhedged EUR, Euro corporates fixed income = Bloomberg Euro Aggregate Corporate Total Return Index Unhedged EU, US inflation linked fixed income = Bloomberg US Inflation Linked Bonds Total Return Index Unhedged EUR, Euro inflation linked fixed income = Bloomberg Eurozone - Euro CPI Total Return Index Unhedged EUR, Global short duration fixed income hedged = Bloomberg Global Aggregate 1-3 Year Total Return Index Hedged EUR, Global long duration fixed income hedged = Bloomberg Global Aggregate 7-10 Year Total Return Index Hedged EUR, Global government fixed income hedged = Bloomberg Global Aggregate Treasuries Total Return Index Hedged EUR, Global inflation linked fixed income hedged = Bloomberg Global Inflation-Linked Total Return Index Hedged EUR, Global corporate fixed income hedged = Bloomberg Global Aggregate Corporate Total Return Index Hedged EUR, Global high yield fixed income hedged = Bloomberg Global High Yield Total Return Index Hedged EUR, Global aggregate fixed income hedged = Bloomberg Global-Aggregate Total Return Index Hedged EUR, Commodities Alternatives = Bloomberg Commodity Index Total Return, Global REITS Alternatives = S&P Global REIT Net Total Return Index, Global infrastructure Alternatives = S&P Global Infrastructure Net Total Return Index, Global private equity Alternatives = S&P Listed Private Equity Net Total Return Index, Global hedge funds Alternatives = HFRX Global Hedge Fund Index.
4 Source: Vanguard calculations as of 31 December, 2021, using data from Refinitiv. Notes: Analysis of S&P 500 index one-year annualised returns between January 1973 and 31 December 2021.
5 Source: Vanguard calculations, based on data from Bloomberg and the OECD, as at 31 October 2021. Notes: 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 1976 to 31 October 2021.For more information, see “Multi-asset investing when inflation is high”, July 2022.