How DFMs deal with asset allocation

Global government bond yields have been falling for forty years as inflation receded, but in the decade since the global financial crisis that process has been accelerated by the policy of central banks buying bonds, which has caused the prices of those assets to rise to record highs. 

The traditional role of government bonds in portfolios is to act as a protector against volatility, while also being a source of income.

The protection from volatility comes from the tendency of investors to sell risk assets in times of uncertainty. That in terms leads to a rise in the price of lower risk assets such as government bonds. 

But central bank bond buying pushed fixed income asset prices higher at the same time as equities rose in value, seemingly neutering the traditional asset allocation diversification method.

When global markets imploded in a pandemic-induced panic earlier this year, government bonds - after an initial wobble - reverted to type, and rose in value, even as the values of almost all other assets fell. 

Yet as government bonds continue to set new records in price terms, can the traditional relationship between bonds and equities be relied on in future? And with central bank action serving as a major determinant of asset price performance, do traditional ways of understanding risk still apply?

US equities

Dan Fasciano, managing director of BNY Mellon Wealth Management, which runs discretionary managed portfolios as part of the £204bn it manages globally, says: “We would look at the US blue chip equity market and the high quality end of the bond market, such as US government debt, and think, even going back ten years, those assets have just gone up and up.

"Over that time period our outlook has evolved, so what we do for clients now is instead of some of the equity allocation, we have put money into high yield bonds and emerging market bonds. They tend to have attractive yields - around 5.5 per cent in high yield today, which is better than that offered by the equity market - but you have the extra layer of safety from the fact you own a bond.”

He added that in a world of low interest rates and with liquidity pumped into the system by central banks, unquoted assets have become more attractive in recent years. 

This is because with funding easy to find, company management teams have less incentive than in the past to float on the stock exchange. That means most investors do not get the opportunity to access opportunities, which, Mr Fasciano feels, may be more attractive investments than some companies listed on private markets.

He says his firm have been marginally increasing exposure to unquoted assets in recent years as a way to get exposure to those companies.

He added that in response to the increased correlation between bonds and equities, his firm has also increased exposure to alternative assets such as hedge funds, as a way of diversifying. 

Mr Fasciano says: “While the public stock markets fell sharply in March, they pretty much recovered quickly, even though the pandemic is still with us. But in the unquoted market and among some alternative assets, the recovery hasn’t happened yet, and that is an opportunity.” 

Managing risk

But deciding on diversification depends on the client in question - and even then, there is no one answer.

Evangelos Assimakos, investment director at Rathbones, says: ““There are many different approaches to asset allocation and they can range from basic to highly sophisticated. Some DFMs will rely on risk profile questionnaires where possible outcomes are linked to various asset allocation models.

"Others employ sophisticated risk analytics across different asset classes to determine the optimum mix for a given risk tolerance. These DFMs may also give more consideration to forward-looking return expectations rather than just historic figures.”

As many adviser clients are now placed in risk-rated portfolios, managing risk is a key consideration.

Alex Harvey, co-head of research at Momentum Global Asset Management, says: “We design a strategic allocation that should by itself, over time, go a long way to achieving the desired client outcome.  We then use tactical asset allocation to help improve that client journey.

"We measure risk not solely by the volatility number or volatility band into which our portfolios fall for risk rating purposes. Instead, we approach risk as the probability of falling short of your investment objective over the investment horizon.

"Of course, there will be bumps in the road and we also give a lot of consideration to downside risk over the shorter term.  By mitigating drawdowns, clients are more likely to remain invested, avoid market timing traps and ultimately realise their longer-term objectives.”

Discretionary managers have the flexibility to adjust positions quickly if they think the time is right. Tom Sparke, investment director at GDIM, a discretionary fund house, says the long-term asset allocation decisions implemented by his firm rarely change, but there are shorter and medium term alterations made.

Chris Holdoway, investment director at Abermarle Street partners, says: “Like many of our industry peers we employ a strategic asset allocation, which defines the broad layout of portfolios. Over this we run tactical positioning that considers shorter term risks or opportunities in markets.

We develop our SAA in-house, with our objective being to optimise the mix of available assets to provide clearly differentiated risk profiles with quantifiable risk and return targets. The SAA takes a ten-year view and should only change significantly if in the past year there has been a significant change in the returns expected from a given asset class over this time frame.”