Beware risks from linkages between asset classes

Allocating capital along the lines of inflation-risk-linked assets, interest-rate-risk-linked assets and credit-risk assets could be a way of keeping a portfolio within risk parameters in a world where asset classes are no longer distinct, writes Charles MacKinnon of Thurleigh Investment Managers.

Reviewing some investment trust data from the 1970s reminded me how much simpler life was then. Assets could easily be identified as UK equities, foreign equities or government stock. Brokers wore top hats and dealers wore bowlers. You knew what was what.

In the equities portion were the various sectors such as industrials, financials, consumer and so forth. Asset allocation, in so far as it was practised, could be achieved by shifting a portfolio between industrial sectors.

Jumping forward to 2010, the distinction between different asset classes has become blurred, mainly as a result of all assets being heavily dependent on credit and so responding to the same market events. You do not know what is what.

The point of asset allocation is that we are trying to reduce the possibility of a total loss of capital, while not removing the opportunity for gain – and there is the rub. Too much diversification and you achieve ‘di-worse-if-i-cation’; too little and you do not prevent loss. The difficulty for an asset manager is that the linkages between assets have changed and become stronger and stranger.

A simple example is that the share price of Amazon, the world’s biggest bookseller, is now more closely correlated to the price of oil than is the share price of Petrobras, one of the largest oil companies in the world.

Class mobility

Rather than allocating capital along the traditional lines of cash, bonds and equity, a better way could be to allocate along the lines of risk: inflation-risk-linked assets, interest-rate-risk-linked assets and credit-risk assets.

The trouble with this approach is that assets migrate between asset classes: is gold an inflation-linked asset or a credit-linked asset? The answer is: it depends when you ask the question and where you are. Over the three months to September 2010, gold fell by 7% in Swiss franc terms, while it rose 4% in US dollar terms.

Add a dash of common sense

We look at five key asset classes: cash, bonds, equity, commodity and absolute return funds. We are clear that a security can only be in the ‘absolute return’ space if it is run against a cash benchmark. We then look at all of the securities in each asset class and examine their correlation with each other.

We can then construct a portfolio and see what we expect to be the volatility and return on an uncorrelated basis and on a correlated basis.