Just because bonds have acted as a buffer against equity drawdowns in the past does not mean they will play the same role in the future, warns Morningstar.
Speaking at a Morningstar event in Sydney, Morningstar Investment Management Asia-Pacific chief investment office Andrew Lill warned against short-term thinking.
In the last two equity drawdowns, financial services professionals had become “very focused” on bonds that had “minimised or diluted the drawdown”, Mr Lill said.
“In most equity sell-downs, bonds protect. In the 1970s, that wasn’t the case,” he said.
He spoke about the efforts of former US Federal Reserve chairman Paul Volcker to combat inflation in the late 1970s, which he said were “not fully anticipated” by investment markets.
“It had huge impacts, whether it be collapse of Bretton Woods, the gold standard, whether it be the Volcker tightening; it was really about increasing interest rates significantly over a short term to try and stamp out inflation, or just the sort of inflation we saw in the 1970s.
“Bonds and equities both went down. Again, [this is] not a prediction, but be aware that bonds and equities don't always operate in different directions.
“So history tells us: think about times when your thesis, your first level thinking, might not work.”
Mr Lill pointed to the “power of checklists” for portfolio managers and the importance of “preparing for the unexpected”.
“Start to build portfolio liquidity, because liquidity gives us two options,” he said.
Liquidity allows investors to re-allocate assets as they became more attractive, Mr Lill said.
Additionally, adjusting portfolios to accommodate for outcomes that are unexpected.
“We keep asking ourselves … ‘what are the range of outcomes that one is not expecting?' And we learn, and we use history, and we plug that into the way that we're managing portfolio so we've always got something as a driver in case bonds and equities don't perform,” Mr Lill said.
“In the 1970s, it was actually commodities that performed very well. That was the buffer in your portfolio to help you deliver positive returns.”