The Global Financial Crisis focused attention on traditional approaches to asset allocation and portfolio construction. In particular, it highlighted the potential for alternatives to the strategic allocation approach (SAA), the asset allocation strategy adopted by many traditional diversified funds.
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. Another example is the lengthening of fixed-income benchmark durations at record low yields.
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 – think IT bubble and bust or the more recent resources boom and bust. 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, for instance inflation + 5%, without making references to market benchmarks but with the flexibility to make meaningful asset allocation changes to achieve the investment target. We believe this better aligns with the ultimate needs of certain investors, particularly those in
retirement and those about to retire.
The critical role of asset allocation in investment 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 worked very well. Prior to the GFC, investment managers had increasingly moved away from thinking that active asset allocation was important. However, a key lesson to come out of the GFC is just how important having a flexible asset allocation is to investment risk and returns. The high volatility and poor returns that characterised the GFC 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.
Traditional SAA funds on average lost close to 33% of their value through the GFC 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, e.g. 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 one-third of its value actually requires a larger gain of 49% just to recover prior losses. 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 which involves negotiating the ups and downs of the market cycle. Essentially, it aims to buy into underpriced 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
In the current environment, where volatility has been relatively low, we’ve seen an extremely accommodative environment for SAA index funds. However, yesterday’s tailwinds may be tomorrow’s headwinds for SAA index funds.
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 largely 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.
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) (AMP Capital) 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 and must not be provided to any other person or entity without the express written consent of AMP Capital.