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A Managing Risk Roadmap for Balanced Portfolios
By: David Chapman, L&G
Diversification is supposed to be the only free lunch, but when historical relationships—like the traditionally inverse one between bond and stock prices—breakdown, public pensions must look at what else is on the menu. This article provides a roadmap to help plans determine optimal approaches for drawdown mitigation.
This is an excerpt from NCPERS Summer 2025 issue of PERSist.
Diversification is supposed to be the only free lunch, but when historical relationships—like the traditionally inverse one between bond and stock prices—breakdown, public pensions must look at what else is on the menu. Below we provide a roadmap to help plans determine optimal approaches for drawdown mitigation.
We begin with broader historical context and simple, objective scenario analysis that can be instructive for setting expectations for US Treasuries as a diversifier or hedge for higher return-seeking assets and then we delve into the full menu available for managing risk.
A stocks-down, bonds-down environment
Recently, markets have had to contend with “Liberation Day,” poor Treasury auctions, renewed and multiple conflicts in the Middle East and the list goes on. Those events are occurring at a time when equities are priced nearly for perfection, and all markets are oscillating between inflation fears and growth worries. So, equities are more vulnerable to corrections and the response from Treasuries is less reliable, depending on which macroeconomic narrative is dominant at the time.
Case in point, 2025 is already—before the year is even half over—outpacing the average full year for the number of days when equities are down more than 1% and Treasury returns are also negative.1
Many investment professionals today have not experienced an environment persistently like this.
Setting expectations for US Treasuries
With yields today at 20-year highs, benchmark duration is lower. Figure 1 shows the well-known relationship between bond yields and duration. As yields move up, duration falls and vice versa. Starting duration is the largest determinant of fixed income returns, making portfolios less sensitive to yield changes today than in recent years. Higher starting yields ostensibly provide more room to fall (i.e., so that total returns are better, despite lower starting duration). However, Figure 2 shows that in today's murky middle of the road duration/yield relationship, rates moving higher is just as likely. That coin flip on yields moving lower or higher is weighted between persistent inflationary pressure and slowing, late cycle growth.
So, what potential protection do US Treasuries currently provide multi-asset investors? Unfortunately, not much. At today's starting duration (approximately six years), a 50 basis point (bps) decline in yield nets a return of 3%. For an investor with a 70/30 portfolio, that offsets a scant -1.3% equity decline. Figure 3 presents this relationship under a wider set of scenarios.
The critical observation is that realizing any material portfolio benefit requires both a significant allocation to duration and, of course, negative stock-bond correlation.
Looking at the full menu
Diversification, duration extension and hedging are the three common approaches to managing risk for a balanced portfolio. Public pensions have been adding additional diversifying strategies for decades. However, some have failed to provide diversification when it was needed most (e.g., some hedge fund strategies) and others have come with a price of illiquidity at a time when liquidity is needed. Other diversifying strategies like commodities and liquid real assets can provide diversification but have not been allocated sufficient capital.
Extending duration is straightforward and easily benchmarked. It may also align with the long-dated cash flows of public plans. However, the portfolio impact is particularly reliant on negative stock-bond correlation. So, investors concerned specifically with positive stock-bond correlation recognize this approach as a double-edged sword for shorter-term rate movements (while still potentially being aligned with more strategic, long-term cash flow objectives).
Hedging can be direct but is generally viewed as more expensive. There are long-held beliefs that the implied volatility premium paid for owning options is excessive (although a negative stock-bond correlation is also a long-held belief…), yet systematic volatility sellers have changed this dynamic significantly. Further, to mitigate stocks-down, bonds-down environments, contingent options and their replication are a viable way to reduce hedging costs. An example of such option is a 95% put on the S&P 500 that only pays off if rates rise 10 bps more than expected over the same horizon.
The right combination of approaches to managing risk ultimately depends on an investor's strategic asset allocation, liquidity profile, funded status and ability to utilize certain instruments. Yet the risk of episodic, or perhaps even secular, positive stock-bond correlation is an opportunity to think creatively and build more resilient portfolios on behalf of your beneficiaries
Endnotes:
1Source: Bloomberg.
Disclosures: This material is intended to provide only general educational information and market commentary. This material is intended for Institutional Customers. Views and opinions expressed herein are as of the date set forth above and may change based on market and other conditions. The material contained here is confidential and intended for the person to whom it has been delivered and may not be reproduced or distributed. The material is for informational purposes only and is not intended as a solicitation to buy or sell any securities or other financial instrument or to provide any investment advice or service. Legal & General Investment Management America, Inc. does not guarantee the timeliness, sequence, accuracy or completeness of information included. Past performance should not be taken as an indication or guarantee of future performance and no representation, express or implied, is made regarding future performance.
Unless otherwise stated, references herein to "LGIM", "we" and "us" are meant to capture the global conglomerate that includes Legal & General Investment Management Ltd. (a U.K. FCA authorized adviser), Legal & General Investment Management America, Inc. (a U.S. SEC registered investment adviser) and Legal & General Investment Management Asia Limited (a Hong Kong SFC registered adviser). © 2025. All rights reserved. No part of this publication may be re-produced or transmitted in any form or by any means, including photocopying and recording, without the written permission of the publishers.
Bio: David Chapman is the Head of Multi-Asset at L&G – Asset Management, America. In his role, he is responsible for the oversight of our asset allocation and quantitative solutions, including overlays, hedging and multi-asset funds. He is also a member of the firm's Investment Oversight Committee.
Dave joined the firm in 2015. Prior to this, Dave was the Chief Investment Officer for ALAS, Inc., a professional liability mutual insurance company. Prior to ALAS, he was with Ascension Investment Management where he was the Managing Director responsible for asset allocation and investment risk management across a variety of institutional investors and plan sponsors. Dave began his investment career as a Portfolio Manager at BlackRock.
Dave earned a BS in Business Administration from Washington University in St. Louis and an MBA from the University of Michigan. He is a CFA charterholder and holds a Series 3 license registered with the NFA.
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