Markowitz portfolio theory in an era of 0 and rising interest rates

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    Michael Pearson


    Could someone at Logical Invest comment on how their strategies and portfolios are dealing with the current 0% interest rate environment and the inevitably rising interest rate environment?

    The context being that the use of bonds in markowitz portfolio theory and risk parity portfolios relies on bonds having a negative correlation to equities. This has been true since the 1980s as we have been in a falling interest rate environment. However, it is not always true. In a rising interest rate environment, bond returns are positively correlated to equities, as was the case for several decades prior. Where we are now, at zero interest rates, the role of bonds isnt clear to me as they offer negative real returns; interest rates can only go up, reducing the value of bond holdings; and in a rising interest rate environment they are positively correlated with equities, with both asset classes falling in value in response to rising interest rates.

    So, how does the logical invest team think about their portfolios and strategies going forward given the fundamentally different environment to the last 40 years, where bonds will no long act as a hedge to equities? Will there be no change? A shift away from bonds? And if so, how will the portfolios be structured to approach the efficient portfolio curve and maximise risk adjusted returns?

    Many thanks in advance!


    Mark Vincent

    Hello Michael and thanks for posting that question I think about it often and there is no perfect answer.

    If you are using the QT software you can see that the Hedging strategies (Hedge) will rotate many uncorrelated assets as follows:
    o GLD
    o GSY

    Treasury Hedge
    o GSY
    o TIP
    o TLT

    If the Bond market becomes uncorrelated to the stock market the Hedge should switch to a different asset class that is performing better and uncorrelated to stocks.
    This is my very simplistic view of how it should work and I am sure LI staff will have a better explanation. We as users also rely on LI to update the hedge and allocation based on market conditions. None of us have a crystal ball but LI tries to adjust the hedge based on the current market conditions. LI also updates the maximum allocation of the hedge and the assets in the hedge as volatility is increasing they apply more allocation to the hedge and I am thankful they do. I do not have the time to analyze every uncorrelated asset and make a prediction on how it will perform in the future.

    Mark Vincent


    The TLT yield is still 1.7% and the FED just told us that they intend to let the rates low for the next 3 years which reduces the downside risk of our 20+year TLT ETF. Rates can still go further down by up to 2% if the US would install negative rates as we have them in Switzerland. Also due to its mostly negative correlation to equity TLT is dampening your portfolio volatility/risk a lot. So, all together treasuries like TLT are a much better addition than cash for your portfolio.


    Hello Michael,

    Both Mark and Frank have a point. I may add that this same argument was present a few years back were yields were again very low. At that point, for the many reasons you mentioned, we created the HEDGE sub-strategy instead of purely relying on TLT for hedging equity risk. The HEDGE sub-strategy added access to TIPS, cash and gold. The adjustment has been towards possible inflation which can be captured via GLD and in part TIPS, or pure deflation via GSY (cash). Interestingly, despite everyone believing interest rates can only go up, TLT managed to be one of the best asset performers and was an excellent hedge to the March 2020 crash. Lesson is we just don’t know what will happen and how long interests will be close or sub-zero. Our HEDGE is flexible enough to deal with a changing environment, even an inflationary one.

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