A critical lesson of the global ﬁnancial crisis (GFC) and its aftermath is that asset allocation is critically important. The period of poor returns and high volatility that characterised the GFC and subsequent years clearly demonstrated that asset allocation, by far, swamps the impact of active security selection or manager selection as a driver of investor returns.
However, will this remain the case if the global economic and ﬁnancial outlook continues to improve in the years ahead? Before this is addressed, it is worth putting asset allocation in context.
What is asset allocation?
The return generated by a diversiﬁed fund or mix of assets will essentially be a function of three things:
The fund’s medium to long term allocation to each asset class (e.g. 30% in Australian shares, 25% in bonds, 10% in property etc.) and hence the market return they generate – technically this is referred to as the fund’s Strategic Asset Allocation (or SAA);
Any short term deviation in the asset mix away from the SAA – this is technically referred to as Tactical Asset Allocation (or TAA); and
The contribution from active management of the underlying asset classes, often referred to as security selection. In the past this was largely undertaken by just one manager but it has become common to use a multi-manager approach in each asset class.
Numerous studies have shown that asset allocation is the key driver of the return an investor will get.1 In fact, if you believe active management of the individual asset classes will add no value, or the fund only invests in indexed funds, then asset allocation will drive 100% of the return. This is just common sense. If a fund is skewed towards shares over bonds or cash, then it will do well when shares outperform and vice versa.
However, in an environment of strong returns from all asset classes and where returns between the two main asset classes of shares and bonds invariably move together, the beneﬁ ts of asset allocation tends to be masked as buy and hold strategies work very well. This is effectively what applied through much of the 1980s and 1990s, which turned out to be an environment where asset allocation faded in perceived importance relative to manager selection.
This begs the obvious question: if we are heading into a new secular bull market in shares, will this see a renewed decline in the perceived relative importance of asset allocation in favour of a return to simple buy and hold strategies?
Our view on equity markets
In our view, while shares are at risk of a further correction in the short term, in a broader context they have likely entered a new cyclical bull market.2 Factors that support this view are discussed below:
The risk of a meltdown in Europe is gradually receding, albeit in ‘ﬁts and starts’. This was highlighted by the relatively muted reaction to the messy bailout of Cyprus, with Spanish and Italian bond yields remaining well below crisis highs. While concern is likely to linger that losses for large depositors and bond holders in Cypriot banks sets a precedent for the rest of Europe, in reality Cyprus is likely to be a special case given its minute size, large banking sector relative to its economy and large non-Eurozone deposit base. Problems in Europe are likely to continue to ﬂ are up occasionally but growth should return late this year or the next.
The US economy is continuing to strengthen, led by an improving housing sector, strengthening business investment, strong proﬁ ts and an improving labour market.
Growth in China looks to have bottomed. While the authorities are trying to cool the property market, inﬂ ationary pressures seem to be benign and indicators are at levels consistent with growth of around 8%.
There are increasing signs rate cuts will help boost proﬁ ts in Australia, particularly for leaner industrial companies. Consumer conﬁ dence is now well above long term average levels, business conﬁ dence is up from its lows and housing indicators are picking up – all the things that would normally be seen after a period of rate cuts.
Global monetary conditions are highly stimulatory and there is plenty of cash on the sidelines which appears to be starting to come back into equity markets.
More signiﬁcantly, after a 13-year secular, or long term bear market, a new secular bull market in global shares appears to be close, led by a rebuilding US economy but also helped by more aggressive reﬂ ation in Japan and gradual structural improvement in Europe.3
Asset allocation to remain critically important
While there will no doubt be periods of very strong returns as we have seen over the past year, asset allocation is likely to remain critically important going forward.
Firstly, the broad return backdrop is likely to remain constrained with not all asset classes doing well. The starting point for returns today is much less favourable than when long term bull markets last started in bonds and shares in 1982. The yields on all asset classes, particularly bonds, are much lower. Shares are unlikely to have the tailwind of rising proﬁ ts relative to GDP as the proﬁt proportion is already high. And both shares and bonds won’t have the combined tailwind from falling inﬂ ation which beneﬁ tted both asset classes thirty years ago as the yield structure fell, providing a huge valuation boost to returns. In fact, our medium term return projections, shown in the next table, imply a 7.5 to 8%p.a return from a diversiﬁed mix of assets. This is well below the average 11.9%p.a return that Australian diversiﬁed funds provided over the 1982-2007 period. In a world of constrained returns, getting the right asset allocation will remain critically important, compared to in a high return world where it's not as much of a focus
Projected medium-term returns, % pa, pre fees and taxes # Current dividend yield for shares, distribution/net rental yields for property and fi ve-year yield for bonds. ^ Assumes forward points averaging 2% points p.a.
* With franking credits added in. Source: AMP Capital
Secondly, the potential return range between the major asset classes is likely to be wide ranging from just 3%p.a for Australian government bonds to just over 10%p.a for Asian shares. Conceivably, given the way markets go the range could be even wider than this. This will only add to the importance of getting the asset allocation right. In particular, being loaded up on low yielding bonds and cash could end up locking investors into very low returns.
Next, while volatility is likely to be down on the extremes seen over the last few years, it is still likely to be relatively high. Public debt problems are likely to continue fl aring up periodically, the world is becoming more reliant on growth from naturally volatile emerging countries and extremely easy monetary policy conditions will provide a source of volatility when they are reversed at some point. This will likely result in ongoing volatility in asset class returns, providing opportunities for asset allocation to add value to investment returns.
Finally, bond and share market returns will likely remain negatively or lowly correlated, providing an opportunity for asset allocation to enhance returns by moving between the two. This is evident in the next chart which shows the rolling three year correlation between bond and equity returns in Australia and the US since 1950.4 Through the 1980s and 90s, return correlations between bonds and shares were mostly positive, refl ecting the common driver of the adjustment to a low infl ation world. But starting over a decade ago, this had run its course and so the correlation turned negative as investor sentiment swung more aggressively between “risk on” (favouring shares) and “risk off” (favouring bonds).
Correlation of monthly equity & bond returns
So while the world is gradually starting to heal which should result in a better environment for shares, asset allocation is likely to remain critical, refl ecting the likelihood of constrained returns, a large variation in returns between major asset classes and ongoing volatility.
A different approach to asset allocation
Apart from a long period of strong returns, another reason why asset allocation seemed to fall out of favour prior to the GFC relates to the perceived mixed track record from traditional TAA approaches within diversifi ed funds. But the problem with these approaches is that they were often constrained by a desire to minimise peer risk and decision making was poor. These outcomes refl ected a committee-based approach dominated by part-timers (usually asset class managers lacking the skills to assess the relative potential between asset classes). And whilst the TAA approach evolved into global tactical asset allocation (GTAA), this tended to be very short term or almost trading focussed and ran the risk of missing out on big picture moves in markets.
Following the experience of the GFC, the focus of asset allocation has shifted more towards taking advantage of extreme swings in the relative performance of different asset classes (such as occurred around late 2008/early 2009) over the course of a business cycle. This approach, often referred to as dynamic asset allocation, sits between the short term trading focus of TAA or GTAA and the medium to long term focus of SAA. A big advantage of this approach is that it can be entirely implemented via highly liquid futures and exchange traded funds and can replicate a diversifi ed mix of assets for a fraction of the cost but with far more fl exibility in varying the asset mix than would apply to a traditional fund. This approach has seen signifi cant growth in offshore markets, notably the US.
Dr Shane Oliver
Head of Investment Strategy and Chief Economist
1. For articles on the importance of asset allocation see R.G. Ibbotson. “The Importance of Asset Allocation”, Financial Analysts Journal. Mar/Apr 2010.
2. See “A new bull market in shares?” Oliver’s Insights, February 2013.
3. See “A new secular bull is close…” Oliver’s Insights, February 2013. 4. The correlation coeffi cient ranges between +1 (perfectly positively correlated, ie the two assets move precisely in the same direction) and -1 (or perfectly negatively correlated). A zero correlation would indicate no relationship between the two asset classes.
Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.