Lessons from history with asset allocation

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(Pictured: Michael Kelly)

By Greg Bright

Past performance may not be much of a guide to future performance, however, you can learn a lot from the history of investment management strategies. Take asset allocation as an important example.

Increasingly, since the global crisis, investors are looking at dynamic asset allocation (DAA) as a strategy for outcome-oriented investing. Michael Kelly, global head of asset allocation at New York-based PineBridge Investments provided an interesting history lesson on a visit to Sydney last week.

For many years asset allocation has been viewed as the most important driver of investment returns. The consensus seems to be, still, that between 80-90 per cent of returns are from asset allocation decisions. Rather than move through the spectrum in a systematic fashion, however, the funds management industry jumped from relying solely on strategic asset allocation (SAA) to add tactical asset allocation (TAA) before finding the medium-term middle ground of DAA.

In the US, the big pension funds had relied primarily on a 60:40 split between, mainly, domestic equities and bonds since the equity cult started to emerge in the 1960s. Kelly says TAA became a big product in the 1970s to capture value out of market volatility.

By the 1980s confidence in TAA had grown but the markets had fundamentally changed, by trending up almost all of the time. TAA managers were taking bets against the market so they tended to lose those bets a lot of the time.

“The early TAA products were flawed. They were essentially US equities versus bonds,” Kelly says. “The 70s offered a predictable trading range… Now, it’s a very different world. Nothing is predictable. You need to know how the world is changing in structural ways.”

The Australian history is a little different because the super industry didn’t get underway in earnest until Award Super in 1986. TAA became very popular for a short space of time in the late 1980s, with the first use of specialists, and into the early 1990s, up until about the bond market crash of 1994.

“Saying asset allocation is the most important investment decision is almost a religion,” Kelly says. “But SAA works primarily when markets trend. By the end of the 90s markets stopped trending.”

Hence the development of DAA, of which there are various styles, normally with time horizons of between one and three years. In Australia, DAA was first proposed by the big asset consulting firms before managers started to offer similar strategies as standalone services. At first managers would say they had always been using DAA, which was true. But when they saw the commercial implications, the standalone offerings emerged.

Some TAA managers morphed into global macro hedge funds during the early 2000s, after the tech bubble, and those which survived have performed well and proved to be a popular hedge fund strategy.

But to Kelly, global macro is more about “a bunch of trading desks taking short-term positions” and charging high fees. “We’re all about the medium term and trying to get different markets right.”

He says: “We see DAA today as fitting in well into super funds. It is a cost-effective strategy which adds to returns and reduces risk.”

Over a long period of time, he says, equities have earned about 4 per cent over cash. But you need 40 years to have the certainty that this will play out. Investors usually want a five to seven-year horizon, which means they need to know when to move to more or less risk premium.

In the past, many investors did not use their SAA ranges. They just rebalanced roughly back to the middle. “After the crisis, it was seen that this didn’t offer protection over the one-to-three-year term,” Kelly says. “You need to be able to shift risk away.”

PineBridge, which has a Melbourne office run by Clinton Grobler, will typically take about 15 bets at any one time, of which five to seven will be large bets.

Its current themes, Kelly says, are that:

  • duration is not your friend
  • Japan, under Abenomics, will work
  • Emerging markets still have some structural changes to work through. “We’re selective, we’re not abandoning them.”
  • China is in a slow-motion slowdown… “It’s hard to make money from equities in the middle of a slowdown”.
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