The Forgotten Half of Portfolio Construction

The forgotten half of portfolio construction – Why “not equity” does not automatically mean defensive

For much of the past decade, portfolio construction conversations have been dominated by equities. US versus Europe. Growth versus value. Active versus passive. Technology concentration. More recently, artificial intelligence.

That focus has been understandable. Equities — particularly US equities — have done much of the heavy lifting for investor returns. When the growth engine is performing strongly, decisions made elsewhere in the portfolio can receive considerably less scrutiny.

We think that may have created an unintended consequence.

The non-equity allocation has too often become the forgotten half of portfolio construction.

Reducing risk has frequently been expressed simply by reducing the equity percentage. An 80% equity portfolio becomes 60%, then 40%, then 20%, with a progressively larger allocation to bonds and other assets assumed to make the portfolio correspondingly more defensive.

But reducing equity exposure is only half of the decision.  What replaces the equity matters just as much.

“Not equity” does not necessarily mean defensive

In reviewing a broad range of model portfolios, one feature repeatedly stands out within lower-risk strategies.  Portfolios with broadly similar equity allocations can contain remarkably different risks once we examine what sits in the remainder.

Government bonds, corporate credit, strategic bond funds, high yield, cash and alternatives can all appear under the broad heading of “non-equity”.

Yet they do very different things.

Corporate credit, for example, may provide attractive income, but it remains exposed to economic conditions and investor risk appetite. When growth deteriorates, credit spreads can widen at the same time that equities fall.

Long-duration government bonds can provide excellent protection during a disinflationary recession, when interest rates and bond yields are falling.

But an inflationary shock can produce a very different outcome: yields rise, bond prices fall and higher discount rates simultaneously place pressure on equity valuations.

Different securities do not necessarily mean different risks.

That distinction matters when the purpose of the non-equity allocation is not simply to generate a return, but to provide resilience when the growth assets in the portfolio are struggling.

Bonds are attractive again

None of this is an argument against bonds.  Quite the opposite.

After years of exceptionally low yields, fixed income once again offers meaningful starting income. Vanguard argues that higher-quality bonds currently offer attractive prospective risk-adjusted returns, while higher starting yields provide a greater cushion against periods of volatility.

But attractive prospective returns and defensive characteristics are not always the same thing.

Vanguard also notes that corporate credit spreads have been historically tight, leaving investors with relatively limited compensation for taking additional credit risk.

Meanwhile, the Bank of England recently highlighted a sustained rise in developed-market sovereign yields, with gilt and US Treasury yields reaching levels not seen since 2008. Higher interest-rate expectations and rising term premia have both contributed.

The Bank has also warned that vulnerabilities in sovereign debt, risky asset valuations and credit markets could potentially crystallise together.

That is an important reminder.

A higher bond yield can improve the prospective return from a defensive allocation. It does not automatically make every bond defensive.

Equity dominance may have hidden the problem

For much of the post-financial-crisis period, this distinction was easier to ignore.

If equities were producing strong returns, imperfections elsewhere in the portfolio mattered less to the overall outcome.  But the investment environment has changed.

Inflation has become less predictable. Energy and geopolitical shocks have returned. Government borrowing is elevated. Interest-rate volatility is higher, and the relationship between equities and bonds is less dependable than it appeared during the long period of falling inflation and interest rates.

BlackRock argues that more frequent supply-driven shocks and greater inflation uncertainty have reduced the reliability of traditional stock-bond diversification. It also notes that equity-market concentration has simultaneously increased, creating greater dependence on a narrower collection of return drivers.

This is precisely when the part of the portfolio that has received less attention suddenly needs to earn its place.

Diversification should be judged by behaviour

At Qualis, we think defensive portfolio construction should therefore begin with a different question.

Not simply:

“How much equity should we remove?”

But:

“What are we trying to protect against, and what should replace that equity?”

Different environments require different forms of defence.

Duration can have an important role. Shorter-duration bonds behave differently. Floating-rate exposure introduces another set of sensitivities. Absolute-return strategies can potentially provide return streams that are less dependent on conventional equity and bond markets.

None is permanently “safe”, and none will work in every environment.  The objective should instead be to combine investments with clearly defined roles whose returns are driven by genuinely different factors.

That is particularly important for lower-risk portfolios.

A cautious investor does not simply need less equity.  They need the assets replacing that equity to provide the resilience they expect from them.

For years, equity dominance allowed investors to concentrate overwhelmingly on the growth engine of portfolios.  Today’s environment is reminding us that the other half matters too.

60/40 tells you the allocation. It doesn’t tell you the defence.

And when investors finally need the defensive part of their portfolio to work, discovering the difference can be expensive.

This article is for information only and does not constitute investment advice or a personal recommendation. Capital is at risk, and the value of investments can fall as well as rise.