Introduction

One of the big swings in thinking around investment management relates to the perceived importance of asset allocation, ie the relative exposure to asset classes like global shares, Asian shares, Australian shares, bonds, unlisted property and cash. Through the long strong secular bull market that went from 1982 through to 2000 (or up to 2007 in Australia) the investment management industry increasingly moved away from worrying about asset allocation to focussing on manager selection at the asset class level. This partly reflected the times where most asset classes did well and so asset allocation was seen as less important and many thought it was too hard.

This all got turned on its head with the GFC and its aftermath of messy markets, coming after a decade of poor returns from global shares, providing a reminder of just how important asset allocation is. As a result asset allocation has made a comeback. This is likely to remain the case even as the global economy and financial outlook continues to heal.

What is asset allocation?

But first some technicalities. The return a traditional fund or mix of assets generates will be a function of three things:

As discussed below, newer approaches to asset allocation are tending to combine SAA and TAA into what is increasingly called Dynamic Asset Allocation or DAA. Numerous studies have shown 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, then asset allocation will drive 100% of the return.

New ways of doing asset allocation

Apart from a long period of strong returns through the 1980s and 1990s during which most assets did well and bonds and equities tended to move together, another reason why asset allocation seemed to fall out of favour prior to the GFC related to the perceived mixed track record from traditional tactical asset allocation approaches. The problems with these approaches were that they were often constrained by a desire to minimise peer risk and decision making was poor, reflecting a committee based approach that was usually dominated by asset class managers who only focused on asset allocation on a part time basis and lacked the skills to assess the potential between asset classes. And whilst the TAA approach evolved into Global Tactical Asset Allocation this tended to be short term trading focussed, and ran the risk of missing out on big picture moves in markets.

After the GFC, the focus of asset allocation has shifted towards taking advantage of extreme swings in the relative performance of different asset classes through the business cycle. This approach, 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. An advantage of this approach is that it can be entirely implemented via highly liquid futures, exchange traded funds or index funds, and can replicate a diversified mix of assets for a fraction of the cost but with more flexibility in varying the asset mix than in a traditional fund. Such approaches also tend to be run by dedicated teams avoiding the “committee of part timers” approach that worked poorly in the past.

But why have active asset allocation?

There are two fundamentals in investing that investors should always be aware of: the power of compound interest and that there is always a cycle. The power of compound interest is demonstrated in the next chart.

Source: Global Financial Data, AMP Capital

Whilst shares are more volatile than cash and bonds, the compounding effect of their higher returns over time results in a much higher wealth accumulation from them. The average return since 1900 from Australian shares at 12% pa is only double that of Australian bonds at 5.9% pa but over the whole period $1 invested in shares would have compounded to $395,550 today versus only $727 if that $1 had been invested in bonds. Over all rolling 40 year periods and virtually all 20 year periods shares trump bonds and cash. This argues for a long term approach to investing.

The problem is that there is always a cycle. Cycles encompass both secular malaises like those seen in the 1930s, 1970s and last decade for global shares that can last a decade or so before giving way to better times, and normal business cycles that result in three to five year cyclical swings in share markets. See the next chart for the latter.

Source: Global Financial Data, AMP Capital

And the problem with cycles is that they can throw investors out of a well thought out investment strategy that aims to take advantage of long term returns and can cause problems for investors when they are in or close to retirement. Cycles also create opportunities for investors to enhance returns.

So for these reasons cyclical variations in asset class returns ideally need to be managed and the best approach to doing this is a rigorous dynamic asset allocation process.

How to manage cycles?

There are essentially three ways to manage cycles:
 

But what if the world continues to heal

An obvious issue is whether the improving global outlook will reduce the need for asset allocation. Our view remains that the cyclical bull market in equities has further to run reflecting still reasonable valuations, better earnings on the back of improving global growth, easy monetary conditions and an absence of the sort of euphoria normally seen at major market tops.2  More importantly, after a 13 year secular bear market, a new secular bull market in global shares appears to be developing led by the US reinventing itself, aggressive reflation in Japan and structural change in Europe.3

However, while there will be periods of very strong returns as we have seen over the last two years, asset allocation is likely to remain critically important going forward:

# Current dividend yield for shares, distribution/net rental yields for property and 5 year bond yield for bonds. ^ Includes forward points. * With franking credits added in.
Source: AMP Capital

Concluding comments

While the world is gradually healing and this should support equities, asset allocation will remain critical for investors reflecting likely constrained returns, a large variation in returns between major asset classes and ongoing volatility. Improved approaches to asset allocation utilising highly liquid and cheap ETFs and futures make accessing asset allocation easier and more cost effective.


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This video must be taken in its entirety and any given chapter viewed in isolation does not represent the entire message.
 

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital

 

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 “The risk of a correction…”, Oliver’s Insights, January 2014.
3: See “The US reinvents itself, yet again”, Oliver’s Insights, February 2014

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.