Multi-asset class investing performance during abnormal market declines

Abstract

The last financial crisis has reminded investors that the fat tails in financial markets are large and what was previously unthinkable turned into reality. Central bankers engaged in unconventional monetary policy. Massive quantitative easing programs flooded financial markets with liquidity. Interest rates and bond yields touched all time lows while developed equities rallied. Moreover debt levels among developed market governments have ballooned. The years which followed the financial crisis were fairly easy to be an investor as various asset classes trended higher. Now with bond yields on various fixed income classes close to their lowest levels and equity markets trading at all time highs, financial professionals are turning towards new asset classes and investment strategies. The aim is to generate positive real returns in a low yielding environment and to better protect investors’ wealth during periods of abnormal market stress. A multi-asset class investment strategy is one such strategy. With the benefit of hindsight it can be stated that during periods of high market volatility single-asset class portfolios, unless exposed to just high-quality sovereign debt, do very little to protect investors. During negative market conditions the benefits of diversification tend to decline as investors strive to flee risky assets. This study analysis the magnitude with which the multi-asset strategy and the market move when tail risk events occur. The results aim to show how well a multi-asset investment strategy protects investors during extreme negative events. Moreover, this thesis strives to answer if such investment strategy limits upside returns. This study confirms that during abnormal market events risky assets tend to sell off all together while high-quality sovereign debt and corporate bonds tend to gain from flight-to-quality. This thesis finds that multi-asset strategies provide downside protection. The level of protection is highly dependent on the portfolio’s balance between risky and less risky assets. Keeping all other things constant, the higher the weighting in high quality debt, the better the downside protection. In line with other studies, this study finds that when asset class reversals are common a rebalanced multi-asset strategy is expected to provide better returns compared to a single-asset class investment.