Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Is it time to be dynamic?
Dynamic asset allocation (DAA) refers to the process of frequently and significantly adjusting the mix of asset classes in a given portfolio. It sits at the stark opposite end of the strategic asset allocation (SAA) approach implemented by most financial advisers and pension funds, which effectively relies on a set-and-forget allocation with some tinkering around the edges. Historically, this portfolio has been constructed with 40% in traditional bond investments and 60% in equities. In recent years, the flood of passive investment vehicles including exchange-traded funds (ETFs) have seen it constructed as cheaply as possible, with little in the way of ongoing changes.
According to Dr Jerome Lander of Dynamic Asset Consulting (DAC), and many other experts in the industry, “the 60/40 portfolio is now a very risky way to run a portfolio.” According to Lander, “defensive assets are broken and growth assets are expensive.” The solution DAC suggests, is the need to more regularly review and adjust asset class allocations, particularly during crisis events.
Lander highlights the fact that the circa 7% returns delivered by the SAA approach over the last decade were driven by a never-ending fall in interest rates, sending the price of all other assets, including property, higher. Yet with rates near zero and the free kick or tailwind all but gone, he thinks we could be entering an environment where you get “absolutely no return” out of cash and bonds. Similarly, he expects little out of property and equities in general over the same period. Of greatest concern in this environment has been the flood of advisers and investors into passive investment vehicles, which, despite being low-cost, expose investors to the worst of both worlds. With most passive vehicles offering long-duration bonds and overweight to the most expensive companies, DAC is concerned that failing to manage the new and increasing risks “just won’t deliver the results that investors need.”
Active, flexibility and willing
The solution, according to DAC and a growing number of advisers, is the need to be more active. The last few years has shown that the basic tenets of Modern Portfolio Theory don’t always hold true, with lower-risk ‘balanced’ options tending to outperform higher-risk ‘growth’ options due to their bond exposures. With many experts pointing to research around the importance of asset allocation in driving returns, the length of time you remain invested in markets is actually more important. But with concerns around valuations, investors are finding it more difficult to maintain exposures in the face of a growing list of concerns.
DAA may be the solution to keeping clients invested during crises and remaining comfortable with their approach. The issue is that it requires advisers to be proactive and willing to make significant changes. There has been a tendency in the industry over many years to ‘play around the edges’. This couldn’t be better evidenced than SAA decisions in which equities or bonds are held at neutral weight or changed by as little as 1% to 2% despite huge changes occurring in the global economy.
CPI + what?
According to Pinebridge Investments, an Asia-based multi-asset manager, the asset allocation required to generate a return of consumer price index (CPI) + 4%, which is the target of most balanced funds, is completely different over different time periods. Over a 40-year period, investors could have held 99% in bonds to achieve this, but over the last ten years, a 45/55% split was required. So, the only way to deliver on return objectives spanning an average 30-year retirement is through a willingness to change and to do so materially.
DAA requires a willingness to be different and an understanding that outright and comparative valuations are important. To truly benefit from a DAA policy an adviser needs to be willing to increase or decrease an allocation by as much as 10%-20% at any given time. Even more importantly, they need to undertake regularly rebalancing at least on a quarterly basis as conditions change. Consider for instance, the adviser who switched 10% of portfolios from bonds to equities in April, delivering substantial outperformance for clients during a very difficult time.
According to Lander, “the world has changed, yet most portfolios recommended by financial advisers are based on a low-inflation environment and falling interest rates” which simply doesn’t exist anymore. Importantly, the DAA approach isn’t restricted to active managers or sophisticated investors, it can just as easily be applied using passive investment vehicles if reviewed and adjusted regularly.
