Correlations between asset classes are near their peak levels and this has a distorting effect on commonly used risk models, according to London-based H2O Asset Management.
"We've reached a point where correlations can't get much further," H2O partner and senior portfolio manager Loic Cadiou said.
Between 2001 and 2006, correlations between assets classes were relatively low and marked an era of great diversification, but since the global financial crisis, correlations have increased dramatically, resulting in a situation where almost all strategies have become highly correlated.
Cadiou pointed to the strong negative correlation between the S&P 500 Index and US Treasuries, which had reached an unprecedented height of -0.8.
"The hedging power against risky assets is so high that (core) bonds are treated extremely nicely by ex-ante risk measures," he said.
"Their protective power has reached a historical high."
From this situation, the only likely scenarios are that either the correlations remain stable or the asset classes become less correlated.
"If the correlation were to remain very negative, bonds would keep on behaving as the exact opposite of risky assets," Cadiou said.
"There would be no possible gains by combining bonds and risky assets. Financial markets would continue to miss one asset class and one source of diversification.
"If the correlation changes though, it can only turn less negative with bond yields moving higher as well.
"With the hedging power of bonds decreasing, portfolios would end up with too large bond positions, weighing negatively on both performance and volatility."
In this last scenario, investors would find their portfolios too exposed to underperforming bonds, he said.
"Portfolios that would lose the most would be those with longer [duration] bonds to balance a larger risky asset exposure, as they would be the most leveraged to a reversal in correlation alongside underperforming bonds," he said.
Investors could not do much but be aware of the situation, he said.
"The worst thing to do is to buy more risky assets and [subsequently] bonds [to offset the higher risks], but your risk models might indicate that you should," he said.
"Not doing too much is already a better strategy."
