Chris Gilchrist: A contrarian take on asset allocation


In 2007/08, having a portfolio diversified across a dozen different asset classes did nothing to help. Everything tanked apart from developed nation government bonds.

If you look at any set of correlation matrices over time, the trend is obvious: the correlation of almost all asset classes has steadily increased over the past three decades. Back in the 1970s, US equities correlated 0.65 with UK equities; now it is 0.9. The list goes on. Even the value of alternatives such as forestry and infrastructure plunged in the last crisis. This is just what you should expect illiquid assets to do.

With this in mind, the latest fund manager waffle about getting better protection with multi-asset funds misses the point. Most of these funds will plunge along with everything else when the next crisis comes along. Ask what did work in the last crisis and you are led to a different conclusion. Ruffer Total Return, Troy Trojan, Personal Assets and Schroder Diversity – funds whose managers were not simply painting by numbers but who worked out which assets ought to act counter to the main trend in a crisis – withstood it best.

The conclusion is this: intelligent asset allocation as a means of controlling risk requires you to allocate significant capital to a few asset classes, not a small amount of capital to many. Managers need to be unconstrained by any benchmark and free to load up on the asset classes they believe in. They will probably be so out of fashion that most people will question the manager’s sanity. The only way to control risk through asset allocation is to be contrarian.

In a world where waves of herd opinion drive capital flows, correlations will probably keep on getting closer. Only two things could stop this trend: capital controls or a fear deep enough to lock greed in the deep freeze. We saw the fear in 2007 to 2009 but it only took a few years to fade.

The idea conventional asset allocation will not effectively control risk ought to worry investment advisers. For the vast majority of clients, capital preservation is a higher priority than obtaining larger returns. Our primary job is not to generate returns for clients but to limit the risks to their capital.

Two types of asset can protect capital against Black Swan risks. One is cash, which is especially relevant for decumulating clients. Some people say it is mad to hold cash when it earns no interest but I say you should look at it the other way round: the assets supposed to be only slightly more risky than cash, namely government bonds, offer “return-free risk” so the risk-adjusted opportunity cost of holding cash is low.

The other is hedge fund strategies where directional market risk is minimised. I do not think eliminating market risk is necessarily a good aim as it can result in taking on more trading and tactical risks.

But it makes sense to reduce naked exposure to bonds and, to a lesser extent, equities as compared with what you would hold in normal times. If you think these are normal times, please quit now.

Chris Gilchrist is director of Fiveways Financial Planning, a contributing author to Taxbriefs Advantage and edits the IRS Report