The case for dynamic asset allocation in a low-return world: part 2
A key lesson from the GFC is just how important having a flexible asset allocation is to investment risk and returns.
In an environment of strong returns from all asset classes and where returns between the two main asset classes of shares and bonds move together, a long-term strategic asset allocation approach has worked very well. Prior to the financial crisis of 2007/2008, investment managers had increasingly moved away from thinking that active asset allocation was important.
However, a key lesson from the crisis is just how important having a flexible asset allocation is to investment risk and returns. The high volatility and poor returns that characterised the crisis and its aftermath highlighted that relative exposure to different asset classes is far more critical to investment returns than active security selection or choice of investment manager. This is the second in a two-part series that looks at the importance of asset allocation in the current environment.
According to AMP Capital’s research, traditional SAA funds on average lost close to 33 per cent of their value through the financial crisis and it took roughly four years to recover the losses.
Markets do recover – albeit in this case with unprecedented help from governments and central banks. Investors with long-term horizons, such as those in the accumulation phase, may simply choose to ignore the fluctuations and ride out the market cycle.
But it may be helpful to note a portfolio shedding a quarter of its value actually requires a larger gain of 49 per cent just to recover prior losses, according to AMP Capital’s research. A key to building wealth, therefore, is to limit these large losses. This is especially relevant for investors with a shorter-term focus or those approaching or in retirement, where being tied to the performance of asset class benchmarks through the cycle may not be the appropriate strategy.
Shorter-term focus requires an alternative approach
With returns from global markets being more constrained and plagued by volatility, and performance varying widely between different asset classes, dynamic asset allocation (DAA) has assumed greater relevance and will remain a critical component of investment strategy as the global economy continues to heal and returns remain constrained. DAA is a flexible approach to asset allocation that involves negotiating the ups and downs of the market cycle. Essentially, it aims to buy into under-priced opportunities and sell out of overpriced situations.
A number of the potential benefits of DAA are related to the flexibility to operate within wider asset-allocation ranges relative to the SAA approach. Here are some examples:
- If an asset class is not expected to produce attractive absolute returns or contribute to lower risk, its weighting in a portfolio can be reduced to a minimal level.
- While market volatility can be unsettling for investors, it brings attractive opportunities for active fund managers with fewer constraints around asset allocation, and these opportunities can ultimately benefit investors.
The current case for dynamic asset allocation
If investors have a view that the next five to 10 year period is going to be largely a re-run of the 1990s or early to mid-2000s, the SAA debate is educational. Over those periods, static allocations to virtually any combination of major asset classes performed well. However we don’t expect shares and bonds to experience the boost to returns that occurred previously. In a world of constrained returns, a large variation in returns between asset classes and ongoing volatility, we believe DAA will remain critically important.
- We are potentially approaching a turning point in the cycle where investors in and near retirement need the flexibility to move defensively or build into value opportunities as certain sectors hit a bottom and turn around.
- Investment cycles are shorter and sharper, and risk flares look to be a more regular occurrence.
- In decades past when yields were higher, there was already a greater probability of achieving client objectives and, therefore, not as much imperative to actually do anything differently. Today, that is changing and any additional value-add is potentially a much larger component of the total.
- While SAA remains a valid solution for investors with long-term horizons such as those in the accumulation phase, it may not be suitable for retirees and other investors facing shorter timeframes amid the current and future challenges of low returns against a more volatile backdrop.
In the current environment where bonds are viewed as expensive due to historically low interest rates and shares are seen as relatively fully priced, the case for dynamic asset allocation is more compelling than ever.