Tactics and player substitutions should also be planned, not totally at the discretion of training staff on the day of a match, akin to a systematic investment management process with rules. Not using tactics in a match is closer to passive management, where players are static but the benefit is that you do not have to pay a manager.
Further to a dynamic approach to bonds, another powerful player is pure inflation exposure. These investments are derivatives-based instruments designed to provide protection against rising inflation.
Unlike traditional inflation-linked bonds, which include bond exposure and may not offer sufficient diversification benefits, pure inflation exposure targets inflation directly through inflation swaps.
Investors can purchase inflation at a fixed rate and profit if expectations rise or if actual inflation exceeds the fixed rate over the investment period. For example, if one-year US inflation is bought at 2.3 per cent and rises to 2.5 per cent shortly after, the investor gains. Similarly, if held for a year and inflation is 2.4 per cent over the period, a gain is realised.
A balanced and resilient portfolio
As per the example, these investments increase in value as inflation expectations rise, providing an offset against the negative impacts of inflation on traditional bond allocations. In periods of rising inflation, interest rates typically increase, causing bond prices to fall.
This negative correlation between bonds and inflation expectations means including pure inflation exposure in a portfolio can enhance diversification and mitigate risks associated with rising inflation. By integrating pure inflation exposure into a bond allocation, investors can benefit from a more balanced and resilient portfolio, particularly during inflationary periods.
Alternatives should be in multi-asset portfolios to provide positive returns but do so at different times relative to equity and bonds. Unfortunately, many alternatives can fall in value unexpectedly during stressed market conditions alongside, equities and bonds.
For managers using alternatives in defence, this feature of correlations increasing when markets fall is not dissimilar to the defence scoring an own goal.
Volatility-based derivatives investments offer a different outcome. Correlations during times of stress tend to become more negative to equity, and the largest positive returns usually come during the worst equity market conditions.
These investments are solely defenders, they never move from defence and are never trying to score, they are only there to protect the portfolio during stressed market conditions. When the cost of these players is mitigated, such an allocation provides exposure to ‘crash protection’.
Like airbags in a car, this distinctive crash protection player is designed to reduce potential portfolio losses during stress events but have negligible impact during normal market conditions.
