Multi-assetMar 22 2012

A benchmark to fix against

twitter-iconfacebook-iconlinkedin-iconmail-iconprint-icon
Search supported by

For most investors, asset allocation is the single most important investing tool at their fingertips.

A decision on whether to have 30 per cent or 70 per cent in stocks can make or break a portfolio. Tactical or strategic changes can make a huge difference either way.

Dealing with the risks of getting it wrong yet allowing returns to flourish is the art of asset allocation. Balancing risks and returns means looking at the margin of safety on offer and being disciplined before taking any decision.

Strangely this simple idea – to see how much room for error is on offer - is frequently discarded. Instead many people fall into the trap of conflating risk with rewards.

But risk does not equal return. Good asset allocation needs to get to grips with both.

Many investors focus only return and never think about risks. Phrases such as “with cash at zero, even a few per cent a year has to be worth something” betray this type of thinking. If you ever hear your investment manager utter these words, take your money elsewhere.

A simple example: “Emerging market equities are risky” – that much many people will acknowledge. But many investors will go on to believe that emerging markets are more likely to yield high returns – irrespective of the valuations on offer. The margin of safety is ignored.

Distinguishing risk from return is important at every stage of the asset allocation process. For successful multi-asset investing it starts with the area investors probably think about least: their benchmark.

Multi-asset benchmarks (like a 60:40 equity / bond split) are a perfectly reasonable idea. But left unchanged for years (as they often are) they will come to dominate performance. Investors need to think – and not accept the status quo.

For example and contrary to popular belief, it is not true that someone with a “high risk/return tolerance” consistently warrants at most times a higher allocation to either risky equities or emerging markets. Riskier behaviour does not typically equate to a greater likelihood of success. Higher returns can come from lower risk areas, even over a long period of time. Ask anyone who invested in equities in 2000.

With multi-asset benchmarks often being left unchanged for years this can be source of woe. Having 60 per cent of your benchmark in equities is great when equities are cheap. By contrast when equities are expensive it could be detrimental to use a benchmark with the bulk of the risk in that asset class.

The bottom line is that with multi-asset benchmarks, the benchmark is the main source of risk. Choosing one is often rushed and the decision rarely re-assessed in a proactive manner.

Review

Why hold an asset class all the time? Multi-asset benchmarks, even when frequently reviewed, encourage this behaviour. Our preferred solution is to use a benchmark-free approach to investing. A benchmark-free approach sets risk tolerances in terms of maximum loss. It does not prescribe an asset allocation.

With a benchmark-free portfolio, fund managers can never blame the benchmark for poor performance. A benchmark-free approach also means the entire asset allocation is always under review.

Without a benchmark, investment managers can properly understand and consider the risks and return potentials of a far wider range of possible portfolio configurations. This should be done continuously, so the portfolios are always best configured in terms of possible outcomes. This calls for a rigorous understanding of the merits of each asset class, and a way of comparing assets on a like-for-like basis.

One manager’s asset allocation philosophy is founded on valuation and scenario testing. It tries to get away from predicting next quarter’s or next year’s economic data to ask a simple question: for a range of asset classes and given today’s valuations, what type of returns could investors expect over a three to five year time horizon?

This simple question forces us as investment managers to look through the economic cycle. Stressing the answers with a range of scenarios means the manager can get a real feel for the possible risks and returns.

Making sure this scenario testing is baked into the investment process from the start, not tagged on to the end, means a robust portfolio can be built bottom up. It means that the valuation risk – arguably, the main risk - is properly quantified across a range of scenarios. This risk can be set against the potential gains. The margin of safety is revealed.

Markets can move very fast. Successful multi-asset investing needs to respond equally swiftly.

With a through-the-cycle valuation approach the manager has an appropriate medium-term anchor to counterweight markets’ movements. When markets rise sharply this anchor allows the manager to broadly measure the shrinkage in the margin of safety. The manager can respond by selling positions to build up a cash reserve for when markets fall. It will not be perfect, but this type of long-term anchoring can help save investors from being caught up in the moment – and to get more asset class calls right.

On equities, some managers are fairly cautious. While many commentators say equities look cheap, equities only look inexpensive based on the current extraordinary high profit margins being maintained. Looking through the cycle this looks unlikely. Simply put, there is not enough margin of safety against the potential problems one should reasonably expect to face.

On government bonds the answer is increasingly no. In the UK for instance, government bond yields are less than most investors can get on their cash. So why take the interest rate risk? As the Greek and Irish experience shows, owning government bonds is far from a risk-free experience.

On corporate credit, particularly high yield, I am more positive. My expectation is for years of sluggish growth. In this case you want to be lending to companies, not taking equity stakes.

And at current valuations you should be reasonably compensated for doing so, even allowing for the level of corporate defaults you would expect through the cycle. In fact, this asset class may well beat equities if a sluggish economic outcome continues.

On this asset class the returns look worth the risk and we are building client portfolios accordingly.

Christopher Mahon is head of investment strategy of global investment firm Momentum