The case for dynamic asset allocation in a low-return world: part 1
The financial crisis of 2007/2008 focused attention on traditional approaches to asset allocation and portfolio construction.
In particular, it highlighted the potential for alternatives in the strategic allocation approach (SAA), the asset allocation strategy adopted by many traditional diversified funds. This is the first in a two-part article that explores this important topic.
Funds adopting an SAA approach maintain a relatively static asset mix throughout the market cycle irrespective of valuations. They are reliant on historical risk-return correlations, and they are heavily influenced by peer-group allocations. SAA approaches are tied to asset-class benchmarks, which are sometimes skewed. For example, Australia’s S&P/ASX 200 index is heavily weighted towards banks and resources companies.
While the SAA approach may be appropriate for investors with long time horizons, particularly those in the accumulation phase of their investment lives, it may not be beneficial to those in retirement or pre-retirement.
In addition, emotional factors such as greed and fear can drive markets to extremes. In a world where bubbles and busts occur, retirees may be better served by a strategy that is more flexible in the face of market swings, which often present shorter-term opportunities.
An alternative approach could give investment managers a mandate to achieve a specific return target, without making references to market benchmarks but allowing the flexibility to make meaningful asset allocation changes to achieve the investment target.
However, before exploring an alternative approach, it may be useful to note that SAA has performed well over recent years. Let’s consider the contributors to that performance and whether those contributors have changed.
Why have SAA index funds performed well over recent years?
Recently, we have had a period of generally strong returns from major asset classes from 2012 until early 2015 as markets recovered from distressed valuations. Economic growth and stronger US earnings underpinned this. Market shocks during this period, such as euro debt issues, were combatted by central bank asset purchase programs, known as quantitative easing (QE). In fact, over the last five years as central banks have pushed interest rates closer to zero, with some countries slipping into negative territory, we have experienced one of the largest bond rallies in history.
In summary, over the cyclical rally from 2012 to early 2015, the following factors acted as tailwinds for SAA index funds:
- Low bond yields along with QE supported a particularly strong period for bonds, which gave investors an incentive to seek higher returns in shares and, more broadly, risk assets. Hence, shares and bonds were highly correlated and provided strong returns in unison. As a result, yesterday’s tailwinds may be tomorrow’s headwinds for SAA index funds.
- Half of the MSCI World index is exposed to North America, which we believe was yesterday’s outperformer and likely to be tomorrow’s underperforming region. We know there are now record profit margins, along with early stages of monetary tightening and the tightening effects on growth from a higher US dollar.
- The duration of fixed-income indices has lengthened at potentially the worst point in the cycle, for instance the duration of the global fixed income index (Barclays Global Aggregate) went from 5.0 years prior to the financial crisis to 6.9 years. The duration of the Australian fixed income index (Bloomberg AusBond Composite) is currently 5.0 years, up from 3.5 before the crisis.
- US shares were a major outperformer over this period given the low US dollar and surge in earnings. The US makes up around 50 per cent of the MSCI world index.
- Given the low-yield environment, corporates and sovereigns alike locked in cheap financing over a longer period. This resulted in a lengthening of the durations of fixed income indices and capital gains for bonds as yields drifted lower. Taking on more duration than actively managed funds were willing to do benefited SAA index funds.
- Moreover, the falling Australian dollar over recent years helped inflate the returns of index funds that were fully unhedged. In this environment, where volatility has been quite low, we’ve seen an extremely accommodative environment for SAA index funds. However, the cyclical rebound we witnessed over this period is against an expected backdrop of materially constrained asset class returns.
- Passive investors in global bonds are potentially exposed to capital losses if average yields rise from their record low levels. Currently a significant portion of global bond issues offer negative yields, while the expected return from bonds relative to the sensitivity of loss from rising interest rates is at all-time highs.
In the second part of this article, we look at how the current investment environment affects asset allocation and how dynamic asset allocation is becoming increasingly relevant as a result of this.