Asset allocation remains the leading driver - by far - of historical performance. In fact, many of the same studies suggest that asset allocation could explain up to 80% or more of the variability in portfolio returns. By successfully forecasting different asset classes’ expected performance, investors can build investment portfolios that will, over the long-term, generate the highest possible returns for a given level of risk.
ASSET CLASSES OVER THE LONG-TERM
By combining asset classes with different return characteristics in a diversified investment portfolio, we can protect ourselves against significant losses. Historically, the three major asset classes’ returns have moved rather differently. Market conditions that cause one asset class to do well often cause another asset category to have poor returns over the same period. If one asset class falls, losses there can be neutralised by better returns in another; the different classes mitigate the severity of each other’s price movements to a degree. As suggested above, the objective is to build satisfactorily diversified portfolios that lower overall volatility; the ultimate goal is for investors not to have to worry about inevitable market fluctuations.
THE STRENGTH OF MULTIASSET CLASS PORTFOLIOS
One might say that the problem with combining stocks and bonds is that adding bonds to a stock portfolio will systematically lower its long-term returns. Is this true? Looking at Chart 2, it is true in the very long-term. However, over the last three years (Chart 1) we can see that a good combination of bonds, equities and alternative investments would have provided slightly better results than the 100%-equity portfolio. Indeed, over the last three years of variable stock market performance, multi-asset class portfolios reduced the effects of the market’s losses and volatility peaks, exactly as they were supposed to. Combining lowly-correlated asset types gave superior returns with less risk. This same combination lost around 4.5% in the correction period of May 2015 to February 2016, compared to the 13.5% loss of a pure equity portfolio. Probably more importantly, the multi-asset class portfolio has been able to recover to a pre-correction level. During the same period, a pure equity portfolio recovered only part of its pre-correction value. In terms of risk/reward, a multi-asset class portfolio is also more efficient (see Table 1) Over the last three years, for a broadly comparable level of average returns, a well-diversified investment strategy generated that return with less than half of the risk of the pure equity portfolio. This is precisely why we should seek options to diversify beyond just stocks and bonds. Additionally, incorporating an even wider variety of relatively uncorrelated assets into a portfolio can further enhance the investor’s chances of mitigating any short-term market losses.
THE ADDED VALUE OF A GOOD ASSET ALLOCATION PROCESS
The example above shows the importance of a good asset allocation process. A long term strategy needs to be defined carefully. NBAD has adopted an asset allocation framework based on Modern Portfolio Theory (MPT), which optimises risk/return in a portfolio context of asset classes. While MPT’s basic assumptions may have been challenged in recent times, we believe that for the foreseeable future it is - and will continue to be – effective as a basic industry practice and standard. We should define the long term view of the asset allocation framework. Firstly, the Strategic Asset Allocation (SAA) - the ‘benchmark’ - represents the neutral, well-diversified allocation across asset classes and their subclasses, and geographic regions, based on long-term assumptions about the constituent assets’ risks and returns. The diversified client portfolios then deviate to greater or lesser degree, asset class by asset class, relative to the benchmark portfolio. For reasons of prudence, these differences vs. the benchmark portfolio vary within acceptable ranges. Changes in tactical weights in portfolios are achieved smoothly, while the constituents of the benchmark are reviewed annually.
In reality, NBAD’s Asset Allocation Committee (AAC) manages three different investment models, according to the following rationales and investment strategy tilts:
- Conservative: Suitable for a client who above all seeks to protect capital and who would be concerned should that not occur. This model portfolio tends to be composed of around 81% in defensive assets, with about 19% in ‘growth’ assets.
- Balanced: Suitable for a client who is prepared to tolerate a degree of volatility in investment values. The model portfolio is made up of around 54% in defensive assets, and 46% in growth assets.
- Growth: Suitable for a client who wishes to invest in a broad spectrum of investments, although predominantly in growth assets, with the chance of achieving higher capital growth.
The portfolio is made up of around 27% in defensive assets, and 73% in growth assets. It will be clear from the discussion above that the benchmark in each case represents the ‘market to beat’. The benchmarks used are kept as simple as possible, and are primarily used for risk profiling and performance measurement. Therefore, the investment strategy selected is directly linked to the appropriate benchmark. In the case of equities, a regional approach has been adopted. For bonds, there is a wide choice, with deep granularity available to make as much use of the full fixed income universe as possible. Finally, starting from the basis of sound strategic diversification across asset classes, it is also very important to take more shorter-term tactical bets when necessary. Of course the timing and magnitude of short-term shifts can be difficult to predict, and changing asset allocation to capitalize on these can be hard work, yet it can pay off handsomely. If the Asset Allocation Committee believes that an asset class will outperform another in an upcoming period, it will move overweight in the former, and underweight in the latter. The AAC is composed of a team of investment professionals with a considerable number of combined years’ experience in the markets.
THE ROLE OF EACH ASSET CLASS IS AS FOLLOWS:
- Equities: There is a logical sequence of increasing exposure to equities as one moves from Conservative towards the Growth profile, consistent with a gradual increase in total risk.
- Bonds: Similarly, there is a sequence of decreasing exposure to bonds as one moves from Conservative to Growth profiles, designed to facilitate the increasing exposure to equities. Bond allocations are considered to carry moderate investment risk in a diversified portfolio context.
- Alternative Investments: Increased potential exposure to ‘alternatives’ (hedge funds and commodities) is a feature of the Growth profile, compared to a lower exposure to this overall asset class in Conservative.
- Cash: Relatively small allocations usually exist in cash, to help with tactical moves in portfolios.
GERARDO AMO Head of Discretionary Portfolio Management
“Up to 80% or more of annualized investment returns in sensible portfolios are driven by asset classes (markets or sectors), rather than by individual security selection.”
“The Strategic Asset Allocation benchmark defines the ‘neutral’ positions across asset classes, with tactical moves deviating from them designed to add value over time.”