RISK-ON or risk-off is a relatively permanent question for many active investors that tends to have implications across the spectrum of asset classes.
Certain assets, such as equities or currencies, are perceived to be risk-on while others are believed to be safe havens - or risk-off.
The latter are generally the type of assets investors will turn to when economic or market conditions do not look favourable.
Deciding whether the environment is risk-on or risk-off is difficult enough for investors in the prevailing environment, which has seen the market distorted by quantitative easing (QE).
However, it is becoming increasingly difficult to identify assets that fall firmly into either of those camps.
This could explain why some investors have given up trying and are turning instead to a passive approach that utilises index tracker funds.
In practice whether an asset class is risk-on or risk-off will depend very much on the drivers of any particular market episode.
For example, gold might be a better safe haven than gilts in a high-inflationary environment, whereas gilts might be a better safe haven than gold when the economy slows and there is less demand for gold jewellery.
It is also very important to consider what state the assets are in before the episode starts.
For example, if bonds are extremely overvalued with low yields their safe-haven potential will be more limited.
It can certainly be argued that QE has forced the price of defensive assets to rise, with the result being that some are seen as not being as safe as they once were.
Many commentators would argue that they look vulnerable to setback and would take many other assets down with them.
Even if all of these factors are considered, it is unwise to expect a mechanical knee-jerk response from asset classes, with correlations often changing significantly over time.
For example, in the sharp sell-off in equity markets in the final quarter of last year asset classes behaved as most text books would predict.
Indeed, shares and high-yield corporate bonds fell while traditionally defensive assets such as gold and government bonds rose in value.
Throughout the period there was a fairly consistent relationship between these two groups of assets in that as risk-on assets fell risk-off assets rose.
Importantly, from the point of view of portfolio diversification, when risk-on assets began to sell off materially in December, the safe havens provided a much needed degree of shock-absorption.
However, more interestingly perhaps, in the first quarter of 2019 the correlations changed and all assets, both risk-on and risk-off, rose.
Why might this be? Perhaps there was a ‘disagreement’ between the two asset categories and at some point one will be ‘proved right’.
Or, more likely, a sudden reversal of direction by the US Central Bank the Federal Reserve in January, which, after raising rates and tightening policy, started to indicate that rates might have peaked.
This appears to have driven all assets higher, with investors extrapolating that this will have a similar impact to the QE period, when the cheap money headed in all directions and a rising tide lifted all boats.
The conclusion is that the traditional characteristics of asset classes which may have been distorted by QE cannot always be relied upon and that investors will have to become more sophisticated in their approach.
When traditional assets do not perform as expected some have turned to alternative investments, whether these be absolute return funds, property or more esoteric investments such as fine art.
Perhaps the answer is to build in more diversification to your portfolio and include as wide a range of assets as possible when it becomes increasingly difficult to rely on the traditional characteristics of traditional asset classes.
Such a strategy should smooth performance as there will be a great mix of some assets performing well while others are lagging.
David Thomson is chief investment officer at VWM Wealth.
Why are you making commenting on The Herald only available to subscribers?
It should have been a safe space for informed debate, somewhere for readers to discuss issues around the biggest stories of the day, but all too often the below the line comments on most websites have become bogged down by off-topic discussions and abuse.
heraldscotland.com is tackling this problem by allowing only subscribers to comment.
We are doing this to improve the experience for our loyal readers and we believe it will reduce the ability of trolls and troublemakers, who occasionally find their way onto our site, to abuse our journalists and readers. We also hope it will help the comments section fulfil its promise as a part of Scotland's conversation with itself.
We are lucky at The Herald. We are read by an informed, educated readership who can add their knowledge and insights to our stories.
That is invaluable.
We are making the subscriber-only change to support our valued readers, who tell us they don't want the site cluttered up with irrelevant comments, untruths and abuse.
In the past, the journalist’s job was to collect and distribute information to the audience. Technology means that readers can shape a discussion. We look forward to hearing from you on heraldscotland.com
Comments & Moderation
Readers’ comments: You are personally liable for the content of any comments you upload to this website, so please act responsibly. We do not pre-moderate or monitor readers’ comments appearing on our websites, but we do post-moderate in response to complaints we receive or otherwise when a potential problem comes to our attention. You can make a complaint by using the ‘report this post’ link . We may then apply our discretion under the user terms to amend or delete comments.
Post moderation is undertaken full-time 9am-6pm on weekdays, and on a part-time basis outwith those hours.
Read the rules here