It’s naïve to rely on bonds for diversification: Atrium

Diversification is a crucial risk management tool but Atrium Investment Management argues genuine diversification requires thinking differently.

Times are uncertain and that usually spells volatility in markets. It’s no secret that the best weapon against volatility is a well-diversified portfolio. But are you really diversified?

According to Atrium Investment Management CIO and Executive Director Tony Edwards, if you’re relying on a simple mix of equities and bonds, the short answer is no.

Just taking a glance at 2022 should give you the answer why. Bonds became highly correlated with equities in a negative market environment, and both fell in value.

“One of the unfortunate parts of this was that investors who thought they were appropriately diversified for that environment, found out they weren’t” Edwards says.

Atrium’s solution to this is a risk-targeted approach to investing and the use of three ‘buckets’ of investments to provide returns within volatility limits: preservers, growth drivers and diversifiers.

And before you ask, the diversifiers are a far cry from a traditional fixed income portfolio.

Atrium uses liquid alternatives, private markets, commodities and currencies as just some of the assets in this pool. It’s no small allocation either. Edwards argues that to have an impact, you need a decent portion of a portfolio dedicated to diversifiers.

“There’s no point in having it 5% of your portfolio. It won’t play a meaningful role. Diversifiers need to have a much greater allocation in the fund to play the role you want if you value diversification,” says Edwards.

In fact, the allocation reached as high as 50% of the portfolio post the GFC in 2010 and 2011. The lowest allocation was around 20%.

Tony Edwards joined Livewire for 7 questions on the market, Atrium’s investment strategy, and what genuine diversification should look like today.

Where do you see markets heading this year?

We think economies are at a turning point and that’s going to flow directly into markets, as interest rates have. We’ve been anticipating a recession for what seems like a long time. It could range anywhere from a significant economic slowdown to a deep recession, or in between. It’s been coming but it’s on our doorstep now.

We’ve got elevated uncertainty around where inflation tops out. Goods inflation is rolling over but services inflation is extremely high, is still growing, and we expect it will remain stickier. Bond markets have been pricing in rate cuts in the US in the latter part of the year. In Australia, the Reserve Bank has shown it is committed to interest rate rises to manage down inflation.

Off the back of this, there’s significant earnings risk for corporates. Bond markets are pricing in a recession, but equity markets are pricing in a recovery from a recession we haven’t yet had. This uncertainty will result in elevated and ongoing levels of volatility and the market will pick up the latest data point as they’ve done for some time.

A lot of the recent earnings season in the US and Australia has been more of a history lesson than where we are going given the slowdown underway in economies . Not surprisingly a whole range of companies are beginning to talk more cautiously and in this environment, the potential for an unforeseen outcome is higher.

What it all means is that we want to be really diversified and have a cautious mindset in the portfolio.

Across a range of markets, you are currently not being rewarded for risk taking. If we look at equities, the valuation metrics have come down. They’re not screamingly cheap and there’s a lot of interest around them but risk is higher and that isn’t overly compelling to us. We’ll need to go through a few more quarters to see what shakes out from an inflation perspective and see what that means for earnings.

Atrium has a dual mandate in its portfolios around risk and return. Can you discuss this and Atrium’s risk-targeted approach?

We seek to maximise the return for a given level of risk and that means we have a performance objective and a risk objective. There are three different risk profiles that run in our funds.

Our Evolution funds have a three-year rolling volatility maximum of 5%, 7% and 9%. Then each of these portfolios have a cash + 2.5%, cash + 3.5% and cash + 4.5% performance objective.

What stands us apart is that we think very differently about risk, and this approach is considered throughout our process, rather than being an afterthought or an outcome of our asset allocation.

We focus on risk targeting with what we term as genuinely diversified portfolios.

The traditional industry approach uses bonds as the primary form of diversification in portfolios. As we saw in 2022 this was not an effective risk management approach, as the underlying risk being interest rate duration saw bonds fall sharply at the same time as equities. The risk of an unintended consequence or risk of shock is higher when you are using a more naïve approach to diversification. So, our solution is genuine diversification which requires a fundamentally different approach to thinking about risk, and the assets you hold to diversify.

At its core, it requires a much deeper understanding of the inherent risk factors impacting investment portfolios and how they relate to each other in different market environments. It also requires a much broader universe of investments and strategies to be able to allocate capital.

Risk management should be intended, and not be an outcome of asset allocation.

What process do you use to identify investments for the strategy?

We use a fundamental process across an unconstrained universe of investments to assess the expected return and volatility of a broad range of investments including equities, fixed income, private markets, and alternatives spanning discretionary macro, long short equity and credit, and trend to name a few. 

We’ll then look for the best risk-reward trade-off across those investments and consider the most efficient way to bring them together to achieve both our risk and return objectives. So at a given point we might see equities as higher return with higher volatility. That’s great for a certain percentage of the portfolio but then we’ll look at alternatives allocations with a slightly lower return but with much lower volatility and these can work together really well in the portfolio.

Atrium uses three broad buckets of assets in their portfolios. Can you describe how these buckets work?

These buckets include preservers which are typically term deposits, cash, government bonds, derivative strategies or option strategies; growth drivers which are more typical growth assets like equities and credit; and then we think about diversifiers where we put things like liquid alternatives, private markets and commodities.

The objective of that diversifying bucket is to provide a differentiated return stream in our portfolios . It’s uncorrelated with equities, which is your largest risk in the portfolio. We target equity beta as close to zero as possible in our diversifiers.

With diversifying allocations to assets like liquid alternatives and private markets, if they’re going to make a difference, you have to have a reasonable allocation to them. There’s no point in having it 5% of your portfolio. It won’t play a meaningful role. Diversifiers need to have a much greater allocation in the fund to play the role you want if you value diversification.

This bucket also needs to work hard in equity market drawdowns to limit downside. Pleasingly in 2022 we have seen a range of the investments we’ve had in this part of the portfolio actually grow capital when equity markets have fallen .

How is Atrium positioned in the current market?

In 2022, we avoided duration in our portfolio and that was driven by the view that at near zero rates , you simply weren’t getting rewarded for duration risk. We also down weighted our equities exposures given the risk of higher rates.

As we progress through 2023 the impact of higher rates on valuations is playing out, and these higher rate settings are now starting to impact the real economy. We’re moving into a period where earnings risk is more elevated and expectations appear too high. In this environment we believe that diversification away from equities will be important and should be highly sought after.

As a result of not wanting to have as much in bonds and a lower allocation to equities, we’ve had strong allocations to liquid alternatives and private markets where we see a more attractive risk reward payoff. We’ve had a much higher allocation to cash. 

That cash is sitting on the sidelines waiting for the market volatility to play out as the economy slows and risk is repriced, and we can be active at that point in time.

We have also deployed range of protection strategies in our funds. Think about derivatives, think about currency exposures such as the Australian dollar or the Japanese yen. These look to limit downside or hold capital in the event we have a bit of a downturn in the economy and a shock.

What opportunities are you looking at for the future?

We’re looking at some really interesting things at the moment.

Equities are always front of mind if they get cheap enough. That’s probably a key opportunity for us at the right time but that is not right now. We’ve been allocating more capital to duration because we think bonds will actually be quite an effective diversifier in the event that the US and Europe goes into a recession. In that event, we think the negative correlation with equities will come back into play.

We are also looking at some investments in the alternatives space, be it things like inflation-linked securities where there has been a significant increase in returns per unit of risk. We particularly like that the underlying risk of natural disaster is unrelated to other risks in the portfolio complementing the return on offer with a great diversifier.

The valuation impact of higher rates has largely played out for a range of risk assets. Now earnings risks are elevated and that’s where we’ll see opportunities.

What is one area of the market that you feel has huge potential, but investors aren’t paying attention to?

Given where we sit in the economic cycle this will depend on how much volatility you are prepared to sit though and your timeframe.

Liquid alternatives are highly prospective for us at the moment, given the role we want them to play in the portfolio, and private markets are also an area of opportunity, albeit selectively given we do see risks growing there.

More broadly there are a range of opportunities we are seeing but I would say these are at the individual asset level rather than the headline level, and you need to dig into the asset class to find the hidden gems. There are selective opportunities in public and private credit, infrastructure and inflation linked investments, as well as equities, but there is still a bit to play out there.

Overall, however, we believe the biggest potential for investors is to truly diversify their portfolios so that they can ride out the turbulent times with less capital loss while still being able to participate in growth as opportunities arise.

Learn more

Tony and the team at Atrium help investors maximise the benefits of diversification by bringing together a blend of best-in-class investment managers and strategies, carefully selected, and incorporated into a range of professionally managed multi-asset diversified solutions. Visit their website to learn more

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