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Time to rethink traditional asset allocation model
by Matthew Peter, Chief Economist, QIC
The stylised traditional asset allocation model – with around 60 per cent of the portfolio devoted to growth assets dominated by listed equities and 40 per cent to defensive assets significantly weighted to government bonds – has served investors well over many years notwithstanding bumps along the way. But no investment idea is sacrosanct.
The traditional asset allocation model needs to be constantly reviewed and judged against its future effectiveness. The future is rarely a simple extrapolation of the past and the traditional asset allocation model has reached its use-by date because a clutch of structural, economic and financial factors will inhibit future returns to listed equities and, in particular, sovereign bonds.
Our baseline expectation of a complicated global economic environment underscored by low but gradually rising interest rates will be especially challenging for traditional assets. While the European and Japanese economies remain sluggish, the US economy is warming and will put upward pressure on American interest rates once the Fed kicks off its tightening cycle in the second half of this year.
Further complicating the outlook is the fall in oil prices, which is temporarily lowering inflation and placing downward pressure on interest rates. Longer term, the drop in oil prices will be positive for global growth, and interest rates can be expected to rise in response to lower unemployment, higher wage growth and rising demand.
Low, but gradually rising interest rates will be hostile to bonds as it leads to lower returns from falling capital values. Sluggish growth and rising interest rates are also challenging for equities.
However, it’s not all bad news.
The slow pace of economic recovery means that interest rate increases will be correspondingly slow. Consequently, the rise in the cost of funds will be gradual and can potentially be offset by company profit growth as labour costs remain contained even as companies’ sales revenue incrementally improves.
The ambiguous and contradictory picture adds up to our belief that risk adjusted returns from major asset classes over the coming five years will underperform their longer run trends (Figure 1).
Global fixed interest (sovereign bonds) will fare worst as interest rates are already low by historical norms and as capital values decline and yields creep higher over the medium term. Listed assets, including equities look likely to suffer a valuation correction.
However, the correction is unlikely to be severe as underlying valuations are not overly stretched, in our view. Hence, we expect listed equities to only slightly perform below equilibrium.
The overall implications for a stylised 60/40 portfolio are discouraging (Figure 2).
A real annual average return of around 4 per cent is the typical objective of most portfolios with traditional asset allocations. By contrast, we expect the 60/40 portfolio to provide a real return of just 2 per cent over the coming five years given our forecasts for low bond returns.
Investors face two broad choices if they are to achieve better returns. First, they could increase their allocation to equities. But the experience of the GFC has made many investors cautious towards the asset class. The other option is to increase the portfolio’s alternatives weighting.
Given our expected return forecasts, lowering the bond weighting from 40 per cent to 20 per cent and introducing alternatives to the portfolio with a weight of 20 per cent would result in our stylised portfolio generating a real annual average return of 3.5 per cent over the coming five years. This shifts the stylised portfolio return closer to the real annual average 4 per cent return target.
How concerned should investors be about the ability of alternative assets to deliver strong returns over the coming five years?
As with equities, prices of infrastructure and real estate assets have been well bid due to investors’ search for yield in a low rate environment. This has led to another similarity with listed equities, which is that standard valuation metrics are showing signs of over-valuation.
The elevated transaction multiples that certain infrastructure and commercial (CBD office) real estate assets have recently traded at around the world has raised questions over valuations in these asset classes. However, historical transaction-multiples may be giving misleading valuation signals in the current low interest rate climate.
At the moment, the real US 10-year sovereign bond yield is below its historical average by around one percentage point. If this difference is being reflected in the cost of capital for infrastructure and commercial real estate assets, and if it were to persist, then the sale prices of recently traded infrastructure and commercial property could be deemed to have occurred at close to fair value.
What might happen to infrastructure and real estate valuations if interest rates were to rise?
Beyond the reach for yield, infrastructure and real estate are attractive asset classes because of: their long durations, which enables a better match of assets and liabilities; their low correlation with equities, in a world where equity valuations are becoming increasingly stretched; and their inflation-protection attributes.
A growing appetite for infrastructure and real estate may be leading to reductions in their risk premia, with the result that the required rate of return on these assets has been lowered (i.e., sustainable transaction multiples are higher).
OECD and Preqin research 1 suggest that institutional investors’ global allocation to infrastructure will rise from around 1 per cent to around 5 per cent over the next few years – a figure that equates to an additional US$4 trillion of demand for the asset class.
An upshot is that growing investor appetite for infrastructure and real estate, in concert with an ongoing low interest rate environment, should be supportive of valuations for some time.
Absolute return products aiming to generate positive returns irrespective of market direction also fit in the alternatives bucket. Market volatility is the friend of skilled absolute return managers as it enables them to exploit the impact of transitory shifts in investor sentiment on market pricing. Moreover, absolute return strategies are lowly correlated with equities.
A climate of rising interest rates and de-synchronised global economic conditions and monetary policy should lift market volatility creating opportunities for absolute return managers.
It would appear that the sun is finally setting on the era of the traditional 60/40 equity/bond asset allocation model, and that dawn is breaking on the era of higher weightings to alternative assets.
There have been other times when it seemed that investors were willing to embrace alternative assets. However, the attraction faded and there was a reassertion of the traditional reliance on bonds and equities.
But this time really could be different. The low yield environment seems entrenched and asset and liability matching strategies are gaining traction.
It seems like the age of alternatives in portfolios has finally arrived.
1 OECD (2011) “Pension funds investment in infrastructure: a survey”, OECD International Futures Programme, Paris, pp1-162, www.oecd.org/futures/infrastructureto2030/48634596.pdf
OECD (2013) Report on pension funds’ long term investments: survey of large pension funds and public pension reserve funds, Paris, pp1-38 www.oecd.org/futures/infrastructureto2030/48634596.pdf
Preqin (2013) Preqin investor outlook: alternative assets H2 2013,
www.preqin.com/investoroutlook
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