Significant gilt weightings continue to be recommended, despite concerning signals on their risk
Government bonds play a pivotal role in a balanced portfolio; there are very few assets that provide the diversification benefits gilts can bring. So often over the last 30 years, when equity markets have zigged, bond markets have zagged, thereby smoothing return profiles.
There is no immutable law suggesting this will always be the case but periods where the relationship did not hold such, as through the 1970s, are uncommon.
Such is the value of the protection offered by gilts, many strategic asset allocation models, such as EValue and Distribution Technology, continue to recommend significant weightings in gilts despite yields falling to all-time lows.
Many advisers closely follow their favoured model’s recommended gilt exposure as part of their investment process, and allocate via active or passive funds. But while this appears reasonable, it overlooks some structural changes that have occurred in the gilt market which could result in portfolios being open to greater risks than the theoretical models suggest.
Many models use capital market assumptions that are heavily influenced by historic price moves as a basis for their estimates of future volatility.
Government bonds are assumed to have no credit risk and any price volatility is largely a result of interest rate risk. This can be measured by duration. Simply speaking, the price of a one-year bond will be much more stable than the price of one with a 30-year life.
Increased interest rate risk
The great bull run in the gilt market has had a profound effect on the composition of the market weighted gilt indices. The general fall in yields has lifted the price of longer-dated issues far more than shorter-dated issues. As a result, the weighting of longer-dated issues in the index has increased. This, coupled with the Government’s bias towards longer-dated issues has materially lengthened the average duration and therefore increased the interest rate risk within the index.
The capital market assumptions used by the strategic asset allocation providers are heavily influenced by the average market moves over the last 10-20 years.
Interest rate risk in the market has risen by 30 per cent over the last 15 years. The change in the index linked gilt market is even more pronounced, as the duration has risen from 12 years to 24 years. As a result, advisers constructing portfolios using gilt funds could end up adopting more interest rate risk in their portfolios than the model assumes.
If we enter a market environment where both bonds and equities fall, high levels of portfolio interest rate sensitivity could act to exacerbate losses. The wobble in the gilt market at the beginning of the year may just be a taster of what is to come. Importantly, these risks are likely to be most acute for advisers’ more cautious clients.
Not the only issue
This is not the only example of the practical difficulty of using strategic asset allocation models. We know of several other potential issues where the theoretical assumptions used within the model are far from representative of how many advisers actually run their portfolios.
One run by a blue chip actuarial firm models equities through two buckets: domestic equity and international equity. This seems quite reasonable. However, the platform where this model sits provides more granular allocation advice. Here, international equities exposure is broken down according to GDP weight as opposed to the more traditional approach of market cap weightings.
Ten to 15 years ago when this process was established, it provided an arguably sensible higher weighting towards the rapidly growing emerging markets and Asia. However, as this rapid growth has been achieved, it is increasingly distorting the numbers.
As a result, the output from this model is now heavily skewed towards the riskier markets in Asia and other emerging regions. We believe this is derived from an arbitrary decision rather than any assumption of risk provided by the actuarial firm.
Unfortunately, this bias has been compounded by the model’s shift out of domestic equities into international equities following Brexit. As a result, the recommended weighting for a very cautious investor is for one third of the equity to be invested in Asia and the emerging regions, whereas the recommended weighting here for a balanced growth investor is over 25 per cent. This strikes us as worryingly excessive.
Advisers should not blindly follow the recommended output from any strategic asset allocation model. To do so runs the risk of investing clients in an unsuitable manner.
Jason Broomer is head of investment at Square Mile Investment Consulting and Research