Since the financial crisis, alpha — the ability to generate returns above a market benchmark — has been relatively hard to come by. Investors who chose to allocate capital to passive strategies, potentially splitting their investments in a 60/40 ratio between stocks and bonds have generally seen positive results. This kind of strategy, which helps reduce management fees, has generally outperformed the hedge fund industry by a not insignificant amount over the past few years, as bond yields have ratcheted ever-tighter, and the equity markets have hit record highs.
It may be, though, that we've come to an inflection point. There's a built-in human assumption to expect the world to continue operating as it has always done. It's worth stopping for a moment to think about the experience of the traders and investment managers whose combined decisions ultimately guide the markets. Despite the Warren Buffetts of this world, the finance industry tends to be staffed by people in their 20s and 30s. Even those at a senior level are generally, like me, veterans only of two decades or so, having joined the market post-1994. Even we older participants have only experienced a series of deflationary shocks met with lower rates and some form of quantitative easing — a world of soluble financial problems. On top of this, many of the analysts working across the investment industry today are often from the post-2008 vintage, meaning they have only ever witnessed rallying markets (at least in the U.S.). When paradigms endure for a whole generation of market participants, it can take a significant leap of the imagination to imagine them ending.
So what do we think is going to change, and why? Let's think first about those 60/40 portfolios. The theory behind this kind of portfolio construction is that diversification can help bring more predictable risk-adjusted returns, so that the fixed-income component outperforms when equities underperform and vice versa. The worst thing imaginable for investors in this kind of passive strategy is positive correlation between the two asset classes, whereby both bonds and stocks move lower in tandem. And yet, as the chart below illustrates, over the past century or so, bonds and stocks have been positively correlated more often than not. It's only this century that we have seen negative correlation become the rule rather than the exception.