Noah Weisberger (left) and Amanda White

The “free lunch” provided by 20 years of negative correlation between stocks and bonds is over, balanced portfolios will become more volatile, and there are few options for investors to engineer portfolios away from this new paradigm, according to an expert at PGIM.

Speaking in a podcast conversation with Amanda White, director of international at Conexus Financial, Noah Weisberger, managing director in the institutional advisory & solutions group at PGIM, said the “efficient frontier” of optimal portfolios will shrink, and in this new regime “there are some combinations of risk and reward that just are no longer attainable as you build a portfolio of stocks and bonds”.

Weisberger previously authored two papers that analysed the drivers behind negative and positive cycles of stock and bond correlation. With the macroeconomic environment arguably supportive of an extended period of positive stock-bond correlation, a newly released third paper looked at how investors should adjust their portfolios in response.

The answer is that optimal portfolios in a positive correlation world will not be very different from optimal allocaitons in a negative correlation world, Weisberger admitted he was surprised by this finding.

Critically, he added, performance of balanced portfolios will be worse on several metrics, and investors will be “stuck with the facts on the ground.”

“Within the narrow context of a balanced portfolio of stocks and bonds,” Weisberger continued, “there’s not a whole lot you can do to mitigate that performance deficit.”

In response to this new investing environment, risk-averse investors may respond by slightly reducing their exposure to stocks. However, perhaps counterintuitively, investors that are less risk-averse may decide to lean more heavily into stocks, with the understanding that “their portfolio is slightly more volatile, bonds are slightly less valuable as a hedge, and the way to compensate for that incremental risk is actually to increase the portfolio’s expected return by owning more stocks,” Weisberger said.

There may also be more room for additional asset classes that bring greater risk, such as commodities, aimed at compensating for greater volatility, he said.

Re-rating unusual

Weisberger warned against using 2022 as a paradigm for markets going forward. The wholesale re-rating of both stocks and bonds in tandem was highly unusual, he said, and investors should not assume the continuation of persistently negative returns for both asset classes.

“In 2022, the performance of a balanced portfolio was less about the shift in correlation from negative to positive,” Weisberger said. “It was much more about really bad realised returns.”

He noted stocks and bonds will likely not be very highly correlated even in a regime of positive correlation, and “there’s plenty of room even within that positive co-movement for the two assets to be diversifiers.” Moreover, with history as a guide, even in the context of a positive correlation regime, bonds could still outperform when equities underperform during crisis periods due to a “flight to quality,” he said.

Unless the terrible returns of 2022 continue, which is doubtful, we are unlikely to witness the death of the 60/40 portfolio, he said. “A portfolio with multiple assets that are moderately correlated still is the right place to go for a risk averse investor.”