Global CIOs tackle uncertain stock/bond correlations, inflation with new risk strategies

A core concept of an institutional portfolio is under scrutiny by a number of investors, with the relationship between stocks and bonds in the spotlight as pension funds continue to assess and upgrade risk mitigation strategies.

For two decades, equities and bonds behaved as expected: A consistent, negative correlation between the two major asset classes meant bonds offered protection to a portfolio when equities sold off. The global financial crisis exemplified this correlation, with the S&P 500 down almost 50% and bonds rallying more than 20% in 2008.

But then in 2022, money managers and investors — many for the first time in their careers — had to deal with positive correlation between the two asset classes, as both equities and bonds sold off.

The phenomenon has some investors worried enough to look closely at the new(ish) trend and some are taking action to mitigate the risk of another positive period for correlations impacting on their portfolios.

“We’ve had this concern for quite a while, because before 2000, the equity/rates correlation was positive, then became negative and has been quite negative the past 20 or so years,” said Christian Kjaer, head of liquid markets at ATP, Hilleroed, Denmark, which had 710 billion Danish kroner ($102.7 billion) in assets as of March 31. “And we always had this worry of ‘what if it changes back to being positive?’” he said.

ATP, which measures risk exposure in the portfolio across equities, rates, inflation and other factors, has a basic portfolio that is “very diversified and low risk, and then we lever that portfolio to the desired risk level,” he said. Broadly speaking, the overall risk level is determined by the volatility of assets and correlation between the assets. “So when volatility comes up, our risk comes up and we need to decide on how to address that. When correlations change, our risk also changes,” he said. While that fundamental dynamic is similar for a traditional 60% equity/40% bond portfolio, “we are slightly more exposed to these things as we use some leverage to get to the right risk level,” Kjaer added.

ATP had started work prior to 2022’s positive correlation, “but intensified the work on what could we do to address this,” Kjaer said.

The result is two new overlay strategies for the portfolio. Executives expect both strategies to be integrated into the portfolio this year.

The first, which has been running as a test, is an on/off-type developed markets strategy, with the positioning either long-risk if correlations are seen that are favorable to ATP’s portfolio or short if they are not.

“It’s a sort of switch,” Kjaer explained. “In normal days it’s just a part of the portfolio, it doesn’t do anything; and if it sees correlation between equities and rates go positive, in combination with losses in the bond portfolio — so a double condition — this combined signal in our analysis seems to be a decent predictor for when to take down risk.”

The signal is algorithm-based and uses intraday high-frequency data to estimate correlations and volatility as quickly as possible.

Kjaer says it’s a “zero-one” strategy and will be “more abrupt by its nature — that puts some limitations on how large the strategy can be.”

The second overlay looks at the need to adjust allocations according to changes in correlation and volatility, and is more gradual.

These innovative strategies are not to make money, but are very much defensive, Kjaer said.

“We are very humble in our ability to beat markets — we want to run these strategies, but we are not going to allocate massive risk budgets to (them.) We believe in general markets are efficient and work well — we try to tweak a little and do it slightly better. These strategies are more defensive and should help us from running into a lot of trouble. We do expect them to generate positive returns, but a big part of the attractiveness is they are a defensive nature,” he said. “It is old-school quant,” he added, noting that executives can override the decision made by the algorithm.

The stock/bond correlation plays an important role in setting the asset allocation for the State of Wisconsin Investment Board's portfolio, said Stefano Cavaglia, a senior portfolio manager in the asset and risk allocation team. The Madison-based board manages $155 billion, including the $132.4 billion Wisconsin Retirement System.

The correlation impacts how the board measures total risk and its capital market assumptions.

SWIB’s staff conducted a joint research project with Robeco’s Lauren Swinkels, head of quant strategy, and Roderick Molenaar, portfolio strategist. Among the findings was that, historically, the stock/bond correlation hovered between -0.3 and 0.3, a range that translates into a significant +/- 20% range for total risk using a 60/40 reference portfolio.

The research also found some evidence that the bond risk-premium moves in tandem with the stock/bond correlation: When the stock/bond correlation is high, bonds often lose their defensive characteristics, “and this is clearly a concern,” Cavaglia said.

The research “allowed us to be early in understanding the consequences of the changes in the correlation between stocks and bonds, and therefore, to better calibrate our position in a changing macro environment,” he added. It’s also “enhanced our awareness of risks to the allocations of our policy portfolio. This and other inputs are well-reflected in our recent decisions for our beneficiaries,” he said.

The stock/bond correlation is something that Mercer has been “looking at actively” too, said James Lewis, Mercer's U.K. CIO.

The economics and asset allocation team has drafted a paper internally looking at stock/bond correlations, the shift in regime and, in particular, how markets have reacted post-COVID-19. “In 2022 we saw the worst year for equities and bonds since 1872 in terms of drawdown — it (was) really significant for markets,” he said. Global equities and bonds both posted double-digit losses in 2022.

Now the firm, which had a total $492 billion in global assets under management as of June 30 mainly as an OCIO, is working to understand “where do we go from here” in terms of markets and the relationship between stocks and bonds.

The team thinks one indicator of correlation is the level that real rates are at. “When high, there’s a more positive correlation; when low or negative, that’s when you tend to see negative correlation between stocks and bonds. But it’s quite hard to call when you get these regime shifts,” he said.

Mercer thinks that, over the very long term, having exposure to equity beta is “the best way to tap into long-term economy growth.” One benefit of a 60/40 portfolio is that, in a recessionary environment where central banks step in, “bonds (are) propped up.” Where there’s a more stressed environment, “there will be some protection.”

Strategies that protect in cases of stocks and bonds falling in tandem are not new, he said, but “people are more used to what’s happened in the recent past,” Lewis said. “The really tricky thing is understanding when it will happen — so we think it’s better having an all-weather, broadly diversified portfolio.”

Some clients are looking for that more diversified approach, searching for uncorrelated alpha sources like hedge funds and commodities, which “can be a good way to introduce something which is less correlated with equities and bonds, and highly correlated with inflation shocks in terms of commodities,” Lewis said.

Commodities and their relationship with inflation has led to an overlay that Industriens Pension, Copenhagen, with about 220 billion Danish kroner ($32.2 billion) in assets, has put in place.

When the pension fund began investing in renewables and infrastructure, executives recognized that part of the buildout requires metal.

Given the commodity-related needs of the green transition, executives moved to hedge the rising costs that could be seen in related sectors and also “the need (to) secure domestic supply lines rather than being dependent on China or Russia for raw materials,” said Peter Lindegaard, CIO at the pension fund.

The team had a conversation with the board and decided to buy into a basket of commodity futures. The biggest part of it is copper, “because we think metals are going to be in high demand.” The hedging program is structured as a total return swap and an external manager looks after the position and rolls the contract.

“It’s an overlay to the portfolio where we think we’re also on this point protecting ourselves more against rising inflation because of the rising prices on raw metals. It’s a way of addressing a future need for raw materials and how that might impact our portfolio,” Lindegaard said.

The program was implemented toward the end of last year. “We’re looking at a world that’s in transition in a lot of ways, and that has some implications for how you invest.”

Executives also have a zero-coupon inflation swap based in euros in place, “which protects us against rising interest rates because of inflation” — effectively converting the nominal bond portfolio to an inflation-linked bond portfolio, Lindegaard added.