As inflation uncertainty persists and the negative stock-bond correlation of the past two decades continues to shift, investor focus has again turned to the fact traditional diversification between asset classes is not working as well, according to Twelve Capital.
In a paper, the specialist insurance and reinsurance-linked investment manager addresses the recent tumultuous environment for the traditional 60/40 multi-asset portfolio, as a rise in inflation and interest rates impacts the negative stock-bond correlation and subsequent diversification benefits.
When the stock-bond correlation is negative, investors are able to rely on the positive performance of one when the other performs poorly, thus the correlation between equities and bonds plays an important role in the diversification of portfolios.
While fluctuations aren’t uncommon, recently, there’s been a notable shift in this correlation from negative to positive, which appears to be primarily related to changes in the outlook for inflation and subsequent interest rate rises.
Twelve Capital argues that as the dust from aggressive interest rate hikes settles, “the focus of investors has sharply turned to back to the fact that traditional diversification between asset classes continues not to be working.”
The company notes that while institutional and private portfolios had relied on the predominantly negative correlation between stock and bond returns over the last 20 years, 5-year stock-bond correlations, notably during periods of increased inflation, have been largely positive.
“While extrapolating from the past may not be a particularly efficient method to predict the future, it highlights critical challenges for institutional investors to generate positive returns while obtaining diversification amid increasingly highly correlated markets,” explains Twelve Capital.
At the same time, the paper finds that continued demand for low-duration investments in uncertain macroeconomic times is in contrast to the recent rise in bond durations in multi asset funds.
“Against this backdrop, the demand for alternative strategies complementary to the traditional Multi Asset portfolio offering diversification, low duration and attractive yields is as acute as ever,” states the paper.
In the current uncertain environment, Twelve Capital says that its Multi Strategy approach, which focuses on the broad diversification opportunities within the insurance sector, provides an alternative for investors.
Between catastrophe bonds and insurance bonds, insurance debt, and listed re/insurance equity, Twelve Capital says that its insurance-focused portfolio approach combines strengths, attractive yield, low duration, and improved diversification / low correlation.
The paper examines the specifics of each asset class Twelve Capital is active in, highlighting the merits and risks of incorporating re/insurance-linked investments into a multi asset portfolio.
“The overall portfolio demonstrates reduced correlation to traditional financial markets and limited exposure to large insurance events. It offers limited interest rate risk and a low portfolio duration due to the floating-rate nature of Cat Bonds and the Insurance Equity component,” says the firm.
Ultimately, the specialist investment manager says that its approach optimises diversification through a blend of insurance-focused investments, which together bring attractive returns, seasonality benefits, and a dedication to sustainable growth.