Markets don't stand still. Should portfolios?
There are two schools of thought, both of which are explored in academia with extensive evidence to support their respective cases.
One is that tactical changes to asset allocation don't make a material difference to portfolio risk and return. The other is that tactical changes to asset allocation can make a material difference to portfolio risk and return. How can these two seemingly contradictory statements both hold true?
The answer is time. In the long run, say for time horizons over 20 years, tactical adjustments don't make a material difference. In the short to medium term, say for time horizons under 10 years, tactical adjustments do make a material difference. And the shorter the timeframe, the more impact tactical adjustments can have.
This is illustrated by what we call the volatility funnel. The volatility and variability of returns of a fixed asset allocation over the short run are higher than they are over the long run. Given the wider potential range of returns in the short run, it makes more sense to be adaptive within that time frame.
By adapting the asset allocation to short-run risk return and correlation conditions, it is possible to narrow the variability of returns. This means obtaining a similar level of returns for an asset allocation compared to a static/fixed-weight counterpart, but improved risk-adjusted returns.
To be clear, an adaptive approach is not the same as market timing where you are trying to time market low and highs. That is notoriously difficult and often counterproductive. An adaptive approach is about being proactive in terms of risk management. This is because while returns are unknown, volatility is relatively consistent.
Being alert to known risks, and clear on-risk budgeting, is key to multi-asset portfolio management. Without it you are simply flying blind.
How does an adaptive approach work in practice? We see three main layers.
First is adapting the overall level of portfolio risk relative to a strategic neutral. This can be done by adapting the overall equity allocation. Because equity volatility is structurally higher than bond and cash volatility, its contribution to portfolio risk is higher than its headline asset allocation. Dialling the overall equity allocation up or down therefore has a material impact on a portfolio’s overall risk position.
Second is adapting the risk exposure within the equity allocation. Traditionally, equity allocations consider countries or regions. But an adaptive approach (which could also be termed an active approach) might also consider sector positioning or factor exposures too. Sectors group equity by business type (for example energy, technology or utilities). Factors group equity by persistent return-driving characteristics (for example value, size or quality).
Portfolio managers can adapt the sector allocation based on the current or expected economic cycle or adapt the factor positioning based on the current or expected market regime. The behaviour of different sectors and different factors in different stages of the market cycle is an area of extensive research in academia, meaning there are precedents to draw from.
Third is adapting the risk exposure within the bond allocation. This means considering credit quality, duration and currency. Credit quality (the relative riskiness of corporate bonds relative to government bonds) means adapting the bond portfolio to the outlook for widening or narrowing credit spreads relative to government bonds based on the outlook for corporates’ business health.
Duration (sensitivity to changes in interest rates) means adapting the bond portfolio to the outlook for rising or falling interest rates and the evolving shape of the yield curve. Currency means considering whether to hedge overseas bonds back into sterling or leave them unhedged, based on the prospects for sterling relative to that overseas currency.
In the long run these adjustments may not make a material difference but in the short term - as we were reminded in 2022 - the duration control of a bond portfolio matters hugely and can be the difference between clients getting good or poor outcomes.
What about alternatives?
A final layer of potential adaptation is to consider the split within the non-equity portion of a portfolio - namely between bonds and alternatives.
We define alternatives as anything that isn't equities, bonds or cash. Naturally there are some alternatives that are higher-risk like commodities, and some that are lower risk like a large proportion of absolute return funds. Adapting the non-equity allocation between bonds and alternatives became increasingly important when the outlook for inflation was on the rise.
In those conditions when real inflation-adjusted yields are negative, it means bonds will fail to hold their value in real terms, hence a higher allocation to alternatives makes sense, albeit with a keen focus on risk control. It was this that led our calls to radically deallocate from bonds in the face of rising interest rates and inflation in 2021.
If the inflation outlook is moderating and the real (inflation-adjusted) yield on bonds is positive, then it makes sense to have a higher allocation to bonds, but still use alternatives as diversifiers. This reflects our current positioning today.
A balance has to be struck between long-run risk return considerations, and short-run performance experience. Not to actively manage the risk of a portfolio is to be asleep at the wheel. Over-trading a portfolio can be counterproductive too. Establishing a disciplined approach to adaptive asset allocation, as a form of active risk management, is prudent, and we think is expected by clients.
We think it's wrong that an evidence-based approach to investing has become synonymous with doing nothing. Indeed, who would rationally pay for a set-and-forget approach to investing? For those wishing to consider all the evidence, there is no shortage of research showing that tactical asset allocation can help mitigate portfolio risks in the short to medium term.
Finally, when time horizons are shorter for older clients, or where risk appetite is more cautious, if there is opportunity to avoid foreseeable harm to portfolio returns, as there was with the bond markets in 2021 and 2022, it's surely a portfolio manager’s duty to consumers to take prudent and adaptive action. Not doing so is frankly harder to support.
