Asset allocation is becoming critically important in a world of shorter and more extreme investment cycles. This is where multi-asset funds come in, writes Janine Mace.
Financial advisers could be forgiven for thinking they just can’t win. As if the Future of Financial Advice reforms weren’t enough, now they are facing calls to junk their traditional approach to portfolio construction.
After years of investment portfolios being based on static asset allocations which use the historical performance of different asset classes to determine the weighting to growth and defensive assets, the latest thinking about portfolio construction is to go back to the past.
Back in fact, to the days when asset allocation ruled.
According to AMP Capital Investors head of investment strategy and chief economist, Dr Shane Oliver, the past decade’s focus on benchmarks and competitors has meant asset allocation has only played a limited role in investment portfolios.
“The 1990s saw a decline in the importance of asset allocation as all assets provided pretty good returns together and under the sector specialist/multi-manager model, in many cases it just didn’t figure at all,” he noted in a recent article.
“However, in a world of shorter and more extreme investment cycles, and more negative correlations between equities and bonds, asset allocation is becoming critically important.”
Many experts agree, and believe the new investment environment means a dynamic approach to asset allocation within investment funds is required.
Schroders head of fixed interest and multi-asset, Simon Doyle, is one who sees views changing.
“Traditional diversified portfolios were constructed around a fixed asset allocation, and in the 1980s and 1990s this suited the conditions of a bull market, but in the past 10-12 years, it has been a very different story. However, asset allocation and portfolio construction have not changed,” he notes.
Doyle believes asset allocation is returning to the heart of the portfolio construction process.
“There has been a reawakening of the importance of asset allocation in the portfolio. If you get better at developing the asset mix, then that is more important than manager or stock selection,” he says.
According to Doyle, the existing approach needs to be refined. “The current model ignores valuations. If there is a zero per cent expected return for equities, why be in them?”
Aberdeen Asset Management senior investment specialist, Leanne Bradley, agrees the current investment environment provides fertile ground for new thinking about the importance of asset allocation.
“Active asset allocation is important in a time of changing markets. There has been increasing focus on it as markets recognise the need to change the investment approach of the past few years,” she says.
Lonsec senior investment analyst – managed funds, Deanne Fuller, is less certain there is a major shift in thinking about investment management underway.
“We see this type of conversation after every major market event. Static asset allocation does not work in all market conditions, but no investment process does.”
Out with the old
The debate has led to growing questioning of the asset allocation approach being used by diversified funds, according to the senior portfolio manager of AMP Capital’s Multi-Asset Fund, Matthew Hopkins.
“Conditions in the past two years or so have led to concerns about traditional diversified funds. They still have a growth versus defensive paradigm. A fund like ours can go from 80 per cent growth to 20 per cent growth, depending on market conditions,” he says.
The discussions around the suitability of existing diversified funds have led to the emergence of a new breed of so-called ‘dynamic asset allocation’ funds, explains Fuller.
“Dynamic asset allocation emerged post the GFC, but in the past 12-18 months, real return or total outcome funds have also appeared.”
She says this is part of a trend towards higher conviction management. “This is also occurring in other asset classes as we are seeing more concentrated portfolios.”
Hopkins believes the ongoing market turmoil has created real investor frustration with the way the current investment model works.
“Even if the GFC had not happened, these types of funds had been gaining traction in the UK (especially among defined benefit pension funds) and they suit the trend in the industry here of moving from the accumulation phase to transition to retirement.”
Bradley agrees the concerns about asset allocation in diversified funds are keenly felt by superannuation investors.
“We believe the active management of asset allocation is particularly important in the retirement phase or for those nearing retirement.”
Another factor in the push for a more dynamic approach to asset allocation is the growing recognition investors are more interested in absolute (rather than relative or benchmark) returns.
Doyle believes the focus by multi-asset or real return funds on achieving an absolute return objective (such as CPI plus 5 per cent per annum), is more in line with what investors are now seeking.
He says the message investors are sending via their continuing use of term deposits is that they live in a world where good performance relative to a benchmark does not help when it comes to paying the bills.
“You can’t spend relative return on groceries, you can only spend absolute return.”
Doyle believes investors want “a stable real rate of return and are prepared to trade away some upside. A term deposit is really a simple form of objective based portfolio”.
Bradley agrees clients are looking for outcomes – not relative outperformance. “It is about protecting the downside for clients – not worrying about underperforming your peers,” she says.
“There is a shift in the mind of end users and the industry needs to change to meet the needs of investors.”
However, the current investment model places little emphasis on achieving an investor’s underlying objective.
“Currently, assessing an investor’s return expectations leads you to being put into a portfolio that is defined by its equity market exposure,” Doyle says. This means investors defined as ‘conservative’ go into a portfolio with 30 per cent equities, while ‘growth’ investors have a higher level.
“If you are not getting rewarded for taking equity risk, then why go there? You need to build a portfolio that achieves a desired outcome. There is a mismatch between the objectives and the asset classes being used,” he argues.
Hopkins agrees: “There needs to be a recognition that you need to spread the return sources as broadly as possible.”
Fuller believes the new breed of multi-asset or real return funds are one way to deal with this problem.
“Traditional static asset allocation funds have done reasonably well for the past 25 years and are not a dying product, but these new funds cater to a different client requirement,” she says.
Hopkins agrees they have a role to play. “If more attention is given to current conditions, then multi-asset is more suitable. However, there is a place for both types of funds – traditional diversified and multi-asset.”
