October 2009

ASSET ALLOCATION: Rethinking the rules

Traditional assumptions about asset allocation, diversity and portfolio theory have broken down, writes Fiona Rintoul, and investors are struggling to find their way...
thinker.jpg“If you are going through hell, keep going,” said Winston Churchill, who also noted: “There is nothing wrong with change if it is in the right direction.”

The last 18 months have been a kind of hell for the financial services industry, and the cries for change have rung out loudly in the asset management industry, as they have elsewhere in the finance sector. The latest area to be bombarded with calls for change is asset allocation.

The headlines have been bold. New world of investing demands change in attitude towards diversification, writes Baring Asset Management, introducing new research on the topic, while Pimco’s managing director, Bill Gross, has talked about the “new normal”, a world where traditional assumptions about asset allocation, diversification and portfolio theory have broken down.

But how do we adapt to the new normal – a world where correlations soared during the crisis and risky assets took the plunge together? What are we to do?

According to Pimco, the evolving financial landscape requires a forward-looking approach to asset allocation that emphasises diversification across global risk factors, not just asset classes, and provides an explicit hedge from ‘tail risk’ events. Accordingly, Pimco has launched a global multi-asset fund, a Ucits III strategy that diversifies based on risk factors rather than asset class. It uses an integrated approach that incorporates alpha, beta and proactive risk management.

Other firms have gone down a similar route. Invesco has just launched a balanced risk allocation fund, which also aims to take account of risk factors by using a risk-balancing approach that seeks to weight each asset class so that it contributes a relatively equal amount of risk to the portfolio. The fund invests in global stocks, bonds and commodities.

The risk contribution from each asset class can vary between 20% and 50% with 33% being neutral. “The balanced-risk allocation approach strives to build a portfolio that performs well in different economic environments and limits the effect of underperformance from any single asset on overall fund performance,” says Scott Wolle, CIO of Invesco Global Asset Allocation.

A more tactical approach
Meanwhile, Barings says its research (see table, overleaf) demonstrates the volatility of major asset classes and highlights the need not to be constrained by traditional asset allocation models. This is not a treatise against diversification – Barings is all for diversification – but rather a call for a sleeker and more conviction-based approach.

“The aim of multi-asset investing is to capture returns where they are available and take risk off the table when the environment deteriorates,” says Percival Stanton, head of asset allocation at Barings. “Since markets deliver unevenly through the business cycle, managers will be increasingly expected to tactically adapt the asset allocation. This helps reduce product volatility compared to equities and achieve the cash-plus returns that clients target.”

The Barings Dynamic Asset Allocation Fund didn’t quite manage that in 2008, when it returned -5.44%. But it did significantly outperform the FTSE All Share index, which plunged -29.9% over the same period.

However, some asset managers sound a note of caution about so-called dynamic asset allocation.
“Call it what you want,” says Nick Lyster, CEO of Principal Global Investors, setting the tone early for the rest of his remarks: “Market timing requires skilled people and a lot of luck as well.”

Ah yes, skill. Lyster makes a fair point. Skill and talent are commodities that will always be in short supply, or to put it another way, as FT columnist Lucy Kellaway once remarked, “The word ‘talent’ is a hideous misnomer since most people aren’t terribly talented at all.”

And as for luck: well, you can’t invest in that.

Lyster acknowledges that the old way wasn’t necessarily perfect. But abandoning a traditional approach to diversification because of the rising correlations seen during the crisis may not make sense either, he suggests.

“If markets stop functioning, which is what happened, everything goes to one,” he says.

The increasing correlations seen in the crisis don’t so much provide a comment on the value or otherwise of diversification, as a lesson in the dangers of excessive leverage, Lyster believes. In the run-up to the crisis, leverage had become so common that it came to dominate and underlying characteristics were no longer in evidence, he says.

Octopus Investments, an award-winning, London-based boutique with €1.1bn under management, which champions “diversification with judgement” (diversification without judgement is certainly an unsettling thought), also highlights the pernicious role that illiquidity can play in correlations.

“[Our method] doesn’t blindly rely on correlation observations of the past but rather asks how likely they are to persist going forward against the prevailing macro-economic environment and financial market dynamics,” says Lothar Mentel, chief investment office at Octopus Investments. “It also takes into account whether the correlation benefit really originates from the nature of the underlying assets or simply from illiquidity.”

Perhaps, then, we’re in danger of throwing the baby out with the bathwater because of one nasty event that hopefully will not be repeated.

“There is a danger of over-reaction,” says Joost van Leenders, investment specialist in asset allocation at Fortis Investments. “We suffered because a lot of correlations increased during the crisis, but this crisis was extreme. We take lessons and we have moved away from illiquid asset classes. But, then again, we have moved into corporate bonds because of low valuations and government bonds was also an asset class that was totally frozen during the crisis.”

Lyster, meanwhile, sees some potential dangers in current attempts to adapt to the new normal. For starters, he points out that the old normal wasn’t really that normal on account of the high levels of leverage that had crept into the system.

“You could argue it was a bit abnormal before,” he says. “The buy-and-hold strategy has been found wanting, not necessarily just through the most recent crisis. On the other hand, relying on being opportunistic is also naïve. People talk a good game, but doing it is difficult.”

Only the phenomenally skilled and fantastically lucky will succeed at such a game, he suggests.
“If you’re skilled and lucky, it makes a lot of sense. But there’s not enough skill and luck out there for this to be a mainstay asset allocation.”

And even if you have in your orbit those twin gods of skill and luck, you might have trouble taking clients along with you, Lyster claims. He tells the story of punting a fantastic investment opportunity round state pension funds in the US during the crisis.

“Only one client pulled the trigger on it and they made a lot of money. The others didn’t have the guts to invest opportunistically.”

Perhaps, then, a dynamic asset allocation fund is the answer? You sign up in a brave moment and the dynamism just happens without further input from you. Certainly, such an approach has worked to some extent in the retail market, as Lyster points out.

Lifecycle funds, though they didn’t cover themselves in glory, did better than retail investors would have done in the crisis if left to their own devices, he says. The funds auto-rebalanced whereas experience shows the average retail investors would have bailed at the bottom of the market.

“We can help retail investors through a period like that if they trust us with their asset allocation,” says Lyster.
Smart approach
But, in any case, dynamism and traditional diversification don’t have to be a contradiction in terms. At Fortis Investments, where they still believe a broad diversified portfolio will outperform a narrow portfolio in the majority of periods, they create their own diversified benchmark for balanced portfolios, called the Smart Benchmark. As well as taking short-term technical bets against that benchmark, Fortis adjusts it from time to time, usually every two to three years.

“In that sense we are dynamic,” says van Leenders. “We could change it every week but we don’t want to.”

Smart Benchmark III has just been defined. In broad terms, this involved moving into more liquid asset classes and out of less liquid investments, such as emerging markets bonds and real estate. There was also a move into equities, inflation-linked bonds and corporate bonds.

The literature for Smart Benchmark III judiciously warns that diversification cannot provide direct protection against a market crash.

“We are not building a portfolio that is completely crisis proof,” says van Leenders. “In that sense, there will always be a risk-return trade-off.”

Indeed. Perhaps the new normal is a classic case of plus ça change, plus c’est la même chose (the more things change, the more they stay the same).

Investors can diversify away – and a recent report from the investment consultant Mercer suggests European pension funds are doing just that with 60% expecting to introduce new investment opportunities into their portfolio to help manage future investment risk – and they can do it every which way they like, but they will always be constrained, not just by available skill, but also by available assets.

Back to Principal Global Investor’s Lyster for a reality check: “The core of everyone’s portfolio will still remain bonds and equities because that’s where the bulk of assets are. If everyone wanted to go into alternatives there wouldn’t be enough to go round.”

©2009 funds europe

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