The Corona crisis reshuffled the cards for investors. Before the pandemic, bonds served as a useful counterweight to equities, as they usually had a negative correlation with them. After Corona, however, this correlation has shifted sharply to the positive, leading to an increase in risk for the portfolio. The central banks’ fight against inflation has also led to increased volatility in the capital markets.
A simple response to the increased risks would be to lower the equity allocation and invest in even more bonds. However, such a shift will make the portfolio even more dependent on the market fluctuations of bonds. And switching from real assets (e.g., equities) to nominal assets (e.g., bonds) weakens inflation protection.
Options and Portfolio Combinations
The investment experts of the fund provider and manager Swisscanto, which belongs to the Zurich Cantonal Bank, see the best solution in hedging the share quota with put options. A put option is a contract that entitles the buyer of the option to sell a certain quantity of a security at a fixed price in advance within a certain period of time. Put options are traded on a variety of underlying assets, including stocks, currencies, bonds, commodities, futures, and indices. “Since put options on equity indices have a strong negative correlation with the equity markets, they offer a high degree of diversification within a mixed portfolio,” says Claude Hess, Senior Portfolio Manager at Swisscanto.
Although there are costs associated with the purchase of put options, these are often justified in comparison with the opportunity costs arising from the reduction in the equity quota and are currently at an attractive level. The protective effect of put options becomes greater the lower the stock market falls.
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The experts at J.P. Morgan believe the resilience of the portfolio should consist of well-combined, high-quality stocks, strong dividend payers, and regional diversification. “The attractive yields could also make alternative asset classes, such as those in the infrastructure sector, more defensive for portfolios while providing some inflation protection,” they write in their investment outlook for the second half of 2023. Finally, investors should also watch the supply constraints that currently exist in the energy, basic materials, food, and labour markets. These will cause economic shifts in the near future and should not be ignored by active investors.
