There is no doubt which asset class is flavour of the month. Fixed income funds have now topped the best-seller charts for seven consecutive months, according to the latest Investment Management Association statistics.
Investors nervous about losing their capital are looking to safer havens and shunning equities. But many, including Goldman Sachs, are predicting the end of a decade-long bull run for bonds. “It’s time to say a long goodbye to bonds, and embrace the ’long good buy’ for equities,” says Peter Oppenheimer, chief global equity strategist.
This should remind investors that fixed income will not be a “fund for all seasons”. Fund experts say in today’s uncertain climate, active asset allocation is key. Marcus Brookes, head of multi-manager at Cazenove Capital Management says the days of “buy and hold” are over, at least for the time being. Adaptability is crucial.
Richard Skelt, co-head of multiasset investment at Fidelity, admits that while sensible asset allocation has never been more important, it is not an easy strategy to undertake. Skelt points to the plight of government bonds to highlight the difficulties of secondguessing the future. In the 1980s, bond yields were in the high double digits but since then yields have fallen to low single digits. This has led to a “steady tailwind of capital appreciation” and bonds have shown strong returns in absolute terms and relative to other asset classes. With government debt yielding two per cent or lower in the big economies, there is little prospect of matching those past returns now.
“A reversion of yields to their longterm average would result in low or negative returns,” Skelt adds. “Were we to use the last 30 years of the government bond index as a predictor of returns over the next 30 years, we would be doomed to disappointment.”
The challenge when setting allocation policy is adjusting to the lack of certainty about returns across the investment landscape. What can we say about likely returns of a stocks, bonds and cash portfolio for the next five years? Or the next 25? Asset allocation needs to be more sophisticated than simply looking at past performance.
Investors also have a broader range of assets from which to choose: “A retail investor selecting an appropriate portfolio for retirement savings or an institution investing on behalf of others is faced today with a bewildering array of choice. The options have expanded beyond recognition since a portfolio of government bonds was the norm,” says Skelt.
The concept of diversification has been around for centuries and it is the twin bull markets in equities and bonds in the 1980s and 1990s that now look like the anomalies. In AD600 the Babylonian Talmud said: “It is advisable for one that he shall divide his money in three parts, one of which he shall invest in real estate, one of which in business, and the third part to remain always in his hands (as it may happen that he will need cash for a profitable transaction).”
In 1952, Harry Markowitz’s modern portfolio theory gave force to the idea that spreading exposure across asset classes reduces volatility, emphasising the importance of portfolios, risk and the correlations between securities and diversification. It is said his work changed the way people invested.
The analysts continue to point out why such a diverse mix works best. Barclays Capital recently compared a portfolio of equities from developed markets, bonds, property, private equity, commodities, infrastructure and emerging market equities with one consisting of equities from developed markets only. It found over a 15-year period the combination of assets enjoyed higher annualised returns (9.8% compared with 9.4% for developed equities) and a lower worst month (-6.2%, compared with -13.3%).
Investors have more tools than ever before to build a diverse portfolio. Ucits III opened up the playing field and many groups entered the fray. Fund groups aim to generate returns in all economic conditions by balancing the asset mix, which has been broadened to include commodities and property. They may now also include fixed-income sub-sectors such as leveraged loans and collateralised debt obligations.
They have also expanded their fund ranges to tap into new asset classes. Ten years ago, overseas equity income funds were rare. That has changed as many overseas markets have matured. Yields on funds such as JPMorgan Global Emerging Markets Income Trusts, BlackRock Latin American, Henderson Far East and Schroder Oriental, more than match the FTSE All-Share yield.
The challenge when setting allocation policy is adjusting to the lack of certainty about returns across the investment landscape.
Emerging market debt followed the sovereign debt crisis. Traditionally, it was considered the higher-risk end of the government bond market. Now it could be argued, given the strength of emerging market government balance sheets, it is less risky than previously.
Throw in the proliferation of exchange-traded funds, with exposure to gold and many other single-asset classes, and funds adopting hedging strategies, and investors have all the tools they need to build a balanced portfolio capable of hitting their target.
But they need to know that correlations between asset classes shift, which should lead them to a more active approach to assets in their portfolios.
Deciding on an appropriate strategic asset allocation involves a wide range of factors. When markets seem particularly unpredictable, disciplined asset allocation provides a way to generate more consistent returns at reduced volatility by taking calculated risks. The importance of a robust and well-considered approach to modelling should not be underestimated.
Asset allocation may have been simpler in AD600, but it is even more important now.