Canadians love asset allocation ETFs, and it's easy to see why. For a low management expense ratio (MER), you gain access to a worldwide portfolio of equities and investment-grade bonds contained in a single ticker. 

Fund managers offer different variants in their asset allocation ETF lineup, with different mixes for investors of all ages and risk tolerances. Descriptors like "growth" (GRO), "balanced" (BAL), and "conservative" (CNS) are commonly appended onto the names of various asset allocation ETFs to describe their intended riskiness.

So, it might shock you to know that in 2022, none of this had made any sense. Take a look at the year-to-date returns (as of July 6th, 2022) for some of Vanguard's asset allocation ETFs below:

1. Vanguard All-Equity ETF Portfolio (VEQT): 100% stocks, YTD -16.61%.
2. Vanguard Growth ETF Portfolio (VGRO): 80%/20% stocks/bonds, YTD -16.20%.
3. Vanguard Balanced ETF Portfolio (VBAL): 60%/40% stocks/bonds, YTD -14.95%.
4. Vanguard Conservative ETF Portfolio (VCNS): 60%/40% stocks/bonds, YTD -13.72%.

A balanced portfolio has drawn down nearly as much as an all-equity one, with none of the upside potential should markets rally. The performance was even worse at the start of June before the recent bond rally. What's going on?

Trouble in the bond market

The answer lies in what's going on in the bond market. Traditionally, investors relied on investment-grade bonds (U.S. Treasurys, AA or AAA corporate debt, and Canadian Federal / Provincial government bonds) to reduce portfolio volatility and drawdowns. 

Bonds (Treasurys and Canadian government bonds) traditionally worked well as a hedge against equity risk because of the following factors:

1. If held to maturity, they produced an overall positive expected return. 
2. Government bonds are considered risk-free in terms of default, making them a prime asset for investors to panic-buy when markets crash (the flight to safety effect).
3. Government bonds historically had a low-to-negative correlation with stocks and decent volatility, which, in line with modern portfolio theory, made them a good diversifier.
4. When a market crash occurs, central banks often stimulate the economy by dropping interest rates, which sends bond yields plummeting and bond prices up sharply. 

Correlation (or lack thereof) is key here. The negative correlation of bonds tends to fade during times of rising interest rates or high inflation. This is occurring in 2022, with the Fed and Bank of Canada raising rates by 75 basis points recently. 

Rising interest rates also increase bond yields, which are inversely related to bond prices, tanking them further. Bond duration also causes long-term bonds (traditionally considered a great equity hedge) to suffer worse than their shorter-term counterparts. 

Hence, investors in a traditional 60/40 portfolio who relied on their bond allocations for protection were left lacking. Bonds fell in tandem with stocks, destroying their diversification benefit and leaving investors nothing to rebalance with. 

What's wrong with the asset allocation ETFs?

Don’t get me wrong here – for the majority of investors, and an asset allocation ETF is the best way to invest passively long term. Over many decades, interest rates will normalize, allowing investors to benefit from falling rates as well. Young investors have the luxury of riding out the current bond bear market or ignoring bonds altogether. 

The issue is Vanguard's (and other fund managers') use of terms like "balanced" and "conservative" as a blanket marketing statement for risk tolerance. An investor planning on retiring soon (or recently retired) is arguably in the riskiest stage of their investment journey. During this time, mitigating sequence-of-return risk (the risk of a year or several of poor returns) occurring is critical.

This becomes difficult if the investor erroneously relies on the perceived safety and lower risk of a "balanced" or "conservative" asset allocation ETF during a rising interest rate environment. Said investors will likely experience deeper than expected drawdowns and higher than expected volatility. This can significantly impact their portfolio value and safe withdrawal rate. 

The definition of "riskiness" used by asset allocation ETFs is predicated on the historical stock/bond relationship, which has held true for many decades but has now broken down for the first time in a while and may do so again in the future. Imagine yourself as a retiree who recently shifted from 100% equities to 60/40 equities yet suffered roughly the same unrealized losses. 

The solution for diversification

I'm a fan of alternative investments, such as commodities and precious metals. These assets might not produce value as stocks and bonds do, but they tend to offer two critical features we need for diversification:

1. A low to a negative correlation between stocks and bonds; and
2. Sufficiently high volatility to act as a counterweight when we need it. 

I used NEO's ETF screener to find a list of low-cost, high liquidity, CAD-denominated alternative ETFs that tracked precious metals or commodities. Investors looking to add further diversification to their asset allocation ETF can consider these. Keep in mind that although adding these alternative funds might reduce volatility and increase risk-adjusted returns, they are likely to reduce total returns. There really is no free lunch in investing.

1. iShares Gold Bullion ETF (CGL): 0.55% MER
2. Horizons NYMEX Crude Oil ETF (HUC): 0.88% MER

Investors can also substitute cash equivalents in the form of money market funds for a portion of their bond allocation. These funds are considered "risk-free," have no interest rate risk, and pay a small yield (around 1.95%). Some examples from the NEO ETF screener include:

1. Horizons Cash Maximizer ETF (HSAV): 0.08% MER.
2. CI High Interest Savings ETF (CSAV): 0.15% MER. 
3. Purpose High Interest Savings ETF (PSA): 0.16% MER. 
4. Evolve High Interest Savings Account Fund (HISA): 0.17%
5. iShares Premium Money Market ETF (CMR): 0.28% MER. 

Disclaimer: This article is limited to the dissemination of general information pertaining to investment strategies and financial planning and does not constitute an offer to issue or sell, or a solicitation of an offer to subscribe, buy, or acquire an interest in, any securities, financial instruments or other services, nor does it constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment.