Beta Investing in Periods of Rising Interest Rates
29 Pages Posted: 14 Aug 2015
Date Written: August 12, 2015
Beta investment strategies attempt to capture the long term appreciation in global asset prices with as little risk as possible. They remain invested in a broadly diversified pool of asset classes and manage risk principally by rebalancing their portfolio. These strategies often include a significant allocation to bonds, an asset class that may be entering a long cyclical downtrend. To assess the impact of bonds on beta strategies in times of rising interest rates, we construct pro-forma “strawman” portfolios that we show capture the essential features of beta investing, and review their performance history for the decade leading to the latest peak in interest rates in 1981. We find that a bond-heavy beta investment approach would have performed well in the 1970’s, principally as a result of the booming price of commodities in U.S. dollars.
Applying profit attribution analysis to the key asset classes of the “strawman” portfolios, we analyze the impact on beta strategies of various actions that could be used to manage bond exposure going forward in all-asset strategies. The best option, in keeping with a diversified investment approach that minimizes market timing, is to reduce the duration of the bond exposure. Such a portfolio can still perform well in periods of rising rates. Performance depends more on the economic environment that drives capital markets than on the sole performance of shorter duration bonds in the portfolio. While the cumulative profit contribution of the bond position may remain negative throughout a cyclical uptrend in interest rates, entirely removing bonds would land a portfolio in a tug of war between the stock and commodities markets which are both cyclical and highly volatile. The risk versus return profile of such a portfolio would be similar to what can be achieved using run-of-the-mill directional investment strategies.
Keywords: Permanent Portfolio, Risk Parity, Modern Portfolio Theory, Beta Investing, Smart Beta, Asset Allocation Theory, Asset Allocation Portfolios, Tactical Asset Allocation, Global Asset Allocation, Harry Browne's Long-Term Investment Strategy
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