How do model portfolio managers think about asset allocation?
Investment returns generally come from a combination of security or fund selection and allocating to the most appropriate asset class.
But in a world of such radical uncertainty, how can one think of asset allocation? If the traditional correlations and inverse correlations have broken down, has the capacity for asset allocation become more or less important?
In this guide we examine the options for clients whose focus is a cautious portfolio, as well as those whose priority is a balanced portfolio.
This guide comes with 60 minutes of CPD.
How important is asset allocation in multi-asset portfolios?
While the range of investment products available to clients grows exponentially, one aspect that remains a firm dividing line is the role of asset allocation within portfolios.
For many investors, their approach starts with a firmly bottom-up analysis of individual funds or securities, and, while paying attention to risk weightings and the need for diversification, pay relatively little attention to the prevailing macroeconomic environment, instead believing such things are unknowable, and focusing on the security selection.
Asset allocation is arguably more important today than it has been at any point in the past 13 years
Others, such as James Burns, who runs a pair of model portfolio ranges at Evelyn Partners, take the view that “asset allocation is very important because if the market goes against a fund you are invested in, no matter how good the fund, it won’t do well in those conditions”.
Andrew Keegan, head of wealth for EMEA at BlackRock, says there are two ways in which asset allocation can be implemented in model portfolios. The first way is through taking a view on the wider economy, while the second is via assigning risk budgets to each portfolio.
He says: “We think asset allocation is the primary driver of return, although of course individual fund selection is also important. Risk is ever-changing so I think it’s important that asset allocation is active.
"We would steer away from the approach where there is a set allocation to bonds or equities for example, as, when that happens, it may mean one can't adjust portfolios to reduce risk or take advantage of opportunities when volatility occurs."
Alex Funk, chief investment officer at Schroders Investment Solutions, says that while asset allocation will always remain crucial, the key difference nowadays is there are more tools available, rather than simply the traditional bonds, equities and cash.
We appear to have reached a critical economic junction that will make or break many portfolios
He says if one is happy to use alternative assets then the range of scenarios one can have exposure to in portfolios is much broader, which enhances the number of risks that can potentially be addressed within a portfolio.
Burns says the asset allocation work complements the fund selection work as, when meeting with the fund managers to whom he allocates capital, his conversations are informed by the asset allocation research of his colleagues.
The importance of asset allocation may be said to wax and wane depending on the prevailing macroeconomic and market environment.
A world in which volatility is low is arguably one in which the standardised 60/40 can work perfectly well.
The decade after the financial crisis was just such a period of very low volatility, but James Sullivan, head of partnerships at Tyndall, says the volatility of recent months means: “Asset allocation is arguably more important today than it has been at any point in the past 13 years.
"We appear to have reached a critical economic junction that will make or break many portfolios. In recent years, the trade had largely been to go full tilt into risk assets and buy long-duration assets. However, in recent months, duration has been the carbon monoxide of asset markets, the silent killer. Few sensed it before it was too late."
There is clear evidence that there is a mathematical relationship between market and economic variables and asset class risk/return expectations
Sullivan adds: “Investment committees will need to contemplate what level of duration is to work best going forward, across both bond and equity markets, and it may be that portfolios need more active, more tactical management than before to jockey for position as the facts change.
“Which jurisdictions will provide the right level of duration, the right level of value-esque exposure? Arguably, the market that led us out of the previous crisis, the GFC, may not be the one that leads us out of this one.
"Valuations across the North American market remain ripe, so investors must heed caution as to how much of a recession is priced in, and where. In the long term, valuation matters.”
For Copia Capital, asset allocation is designed to be the “key driver” of investment returns, and the firm uses a quantitative analysis model that Peter Wasko, senior portfolio manager at the firm, says analyses hundreds of different “market and economic variables to estimate the expected risk and return for different asset classes.
"This ensures that we fully understand the potential impacts of market fluctuations and macroeconomic conditions on our portfolios to balance the risks more effectively against potential rewards.”
He says there is “clear evidence that there is a mathematical relationship between market and economic variables and asset class risk/return expectations".
Only a very highly active asset allocation approach would have avoided these falls by pivoting to cash and alternatives
The function of a quantitative screen is to do the maths on that correlation. They presently favour value equities over growth equities due to the prevailing inflationary environment, especially with interest rates rising.
Antony Webb, deputy head of model portfolios at Quilter Cheviot, says: “In 2022 both equities and bonds have fallen – two core components of most investment portfolios. Only a very highly active asset allocation approach would have avoided these falls by pivoting to cash and alternatives.
"The scale of the pivot required and the impact of getting it wrong means few providers will have been able to implement this – such significant swings to portfolio construction make it hard for advisers to assess suitability when recommending portfolios to clients.
"Therefore ability to be active within asset classes is key (rotating equity exposures, adjusting credit quality of bond portfolios, managing interest rate risk) – activity in these areas has been key this year to managing risk."
Webb regards asset allocation as pivotal to effective portfolio construction.
david.thorpe@ft.com
Using asset allocation to diversify a balanced portfolio
A rocky year for markets has at least helped to bust a few common investment myths.
A sharp sell-off has reminded many that growth stocks are not invincible, that benchmarks do not always go up in a straight line and that seemingly uncorrelated assets can still fall in tandem, given the right circumstances.
That third point is especially concerning for advisers who direct client money into so-called 'balanced' portfolios, as well as for those who run such portfolios.
Designed to take a good portion of equity risk but with some diversification against stock market falls, such portfolios have tended to predominantly rely on bonds as a source of ballast even as alternative asset classes have proliferated.
Diversification
Data compiled by Asset Allocator, a sister title to FTAdviser that tracks a large sample of DFM model portfolio ranges, shows that the average balanced portfolio from this cohort had nearly a quarter of its assets in fixed income as of the summer.
With the average equity weighting coming to nearly 57 per cent, that leaves little room for other diversifiers, and a lot of pain related to the huge bond sell-off of the last year or so.
To highlight the extent of that pain, it is worth noting that the average fund in the Investment Association’s UK Gilts sector is down by some 24 per cent over the year to October 20, with its equivalent in the IA Sterling Corporate Bond peer group down by roughly a fifth.
That has meant investment strategies relying on a mixture of equities and bonds – be it in the DFM space or elsewhere – are sorely lacking the balance and diversification their clients need.
The risk profile of equities may intimidate lower risk investors, but recovery potential is stronger
But are there any alternatives? With inflation and interest rate rises continuing to pose a threat for bonds, investors will be tempted to look elsewhere for diversification – including further up the risk spectrum.
From the few successful absolute return and hedge funds out there to private equity, music royalties, infrastructure, property and esoteric funds in areas such as ship leasing, a handful of options have looked appealing as an alternative diversifier against equity exposure, despite potentially carrying greater risk.
Investors may also be tempted to back risky assets that should thrive in the current economic conditions, from commodities that benefit from inflation to bank shares as a play on higher interest rates. Separately, some may simply be taking more risk as a way of locking in a recovery from recent losses.
Quilter Cheviot’s deputy head of managed portfolios, Antony Webb, notes: “I think some investors and advisers are considering moving up the risk spectrum, not necessarily to achieve diversification but to have a better chance of capital gain in future.”
He adds: “The risk profile of equities may intimidate lower risk investors, but recovery potential is stronger.
"Some clients and advisers will be looking at whether they can adopt a longer time horizon for their investments, taking on more equity exposure in pursuit of longer term opportunities for capital appreciation."
Risk and reward
Investors who have found themselves able to weather the recent ups and downs of markets and can stick to a long time horizon may well be happy to embrace riskier assets, but a question remains as to whether diversification can be found higher up the risk spectrum at a time when bonds are floundering.
Some of the few successful funds of the last year may well be seen as racy options; if we look at investment trusts operating in alternative asset classes it is esoteric names such as merger arbitrage vehicle Gabelli Merger Plus +, hedge fund BH Macro and private equity fund Literacy Capital that have delivered strong shareholder returns over the year to October 20.
While not the case for two of these three examples, funds with an alternative remit will also often have the added appeal of chunky, and often reliable, dividend payments.
Asset allocators do already make use of some seemingly riskier diversifiers, and with bonds running into trouble in the past year there is a good chance some have already upped their weightings in such areas. However it is likely that bonds continue to maintain a decent presence in many portfolios and for alternatives to serve as satellite positions, for various reasons.
Firstly, it is worth noting that alternatives are not necessarily uncorrelated to bonds themselves, meaning any problems in the fixed income space can hurt them too. This was amply illustrated by the recent failed “mini” Budget, which sent the yields on UK gilts soaring.
Removing bonds altogether from a portfolio would create a huge imbalance
Investment trusts in the real estate and infrastructure space were hard hit – partly because a rise in the 'risk-free rate' available from an asset perceived to be safe such as a government bond pushes up discount rates and eats into the value of future cash flows and a portfolio’s stated net asset value.
But backing riskier diversifiers also involves taking more idiosyncratic risk even if they are uncorrelated to equities and bonds.
Turning again to the investment trust space, the Civitas Social Housing fund has struggled because of regulatory concerns and a short seller attack last year. Other names, such as the music royalty funds, face their own questions about how assets are valued and how resilient they prove in an economic downturn.
Finally, a fixed income sell-off may actually have led us to a better time for the asset class. Meera Hearnden, investment director at Parmenion, notes that while times have been rough for bonds, they now offer yields not seen in many years. She also argues that the breakdown in negative correlation between equities and bonds should prove temporary, and says fixed income remains a key diversifier for a balanced portfolio.
“Removing bonds altogether from a portfolio would create a huge imbalance, not to mention disproportionately increase risk, so anyone that does this would need to be very careful in managing their client’s risk expectations,” she says.
David Jane, who jointly runs a suite of multi-asset funds at Premier Miton, says markets will continue to struggle until the US Federal Reserve signals that its policy of increasing interest rates is at, or near, an end. Until then he feels most assets will struggle, and so is striving to keep his portfolios "liquid and conservative".
david.baxter@ft.com
Difference between risk and capacity for loss in a changing world
'Character building' is rather a euphemistic description for recent market conditions, but in some ways the term is appropriate.
Painful as it might seem at the time, investors can learn plenty from a fully fledged bear market – whether it is the very real need for diversification or the dangers that lurk in crowded trades.
Other lessons relate to an investor’s character itself, and just how much volatility they can tolerate.
But it is worth outlining the difference between an investor’s appetite for risk – something that can sometimes be misleading – and their actual capacity for loss.
Widely as investors use it in different contexts, risk might be seen more as relating to an investor’s attitude and how able they are to tolerate sharp portfolio falls without being tempted to bail out together.
As a representative of Quilter Cheviot notes: “As far as clients are concerned, their appetite for risk may be as simple as how comfortable they are seeing their portfolio fluctuate in value. Understanding this is key for DFMs as clients may lose confidence and sell their portfolios if it falls further than they are comfortable with, thereby locking in a bad return.”
Handling volatility
As intermediaries will know, a service to provide for a client will simply be to keep them calm when markets are rocky and prevent them from crystallising a loss – from stressing the fact that markets recover to pointing out that valuations should in fact look more attractive in difficult conditions. However, reactions to volatility may also highlight areas where changes are required.
Rob Morgan, Charles Stanley's chief analyst, says episodes of market turmoil can “reveal vulnerabilities in your portfolio and just how volatile certain elements can be”.
He adds: “If this is a shock you weren’t prepared for, it may be time to revisit investment goals and risk appetite, and whether you have too much in the most volatile assets”.
This argument can apply to your broad asset allocation choices, including a portfolio’s equity weighting, but also your level of general diversification, and whether an investor has an appetite for fashionable but volatile investments.
Fans of the blockbuster Scottish Mortgage Investment Trust have seen the shares lose roughly half their value in the last year following a very strong run in the earlier pandemic. Other major funds have also struggled, as have hot investments including many ESG and thematic funds.
On a separate note, clients who do like a speculative investment – from playing cryptocurrencies to speculatively picking individual stocks – may have learned the painful way that such positions should remain fairly minor in their size.
It remains important, however, to stick with a long-term approach and embrace risk if possible when it comes to areas such as asset allocation.
While a client may sleep better at night by avoiding equity-like volatility, it is the same volatility that will drive much stronger returns over the longer term.
Morgan notes: “You could add areas to diversify to help smooth out returns, though bear in mind this may dilute the long-term potential of a higher risk portfolio and that any changes should be thoughtful and measured rather than made in haste.”
On a similar note, if a client struggles to stomach risk and needs to take a more defensive approach, it may seem more sensible to deploy new money into a more defensive portfolio rather than selling down seemingly riskier assets that have fallen in value.
Capacity for loss
And yet risk tolerance is arguably less important than a client’s capacity for loss, which will dictate how severe a portfolio loss they can handle financially.
Capacity for loss will depend on numerous factors, from the size of the portfolio to the alternative sources of income an investor might have and their time horizon.
Those who, for example, have debt or no cash savings would be vulnerable to a sharp drop in their investments – as may have been the case with some individuals who backed more speculative investments earlier in the pandemic.
Turning to those more likely to be using advisers and DFMs, those who rely on portfolios to generate a retirement income or to create some growth – either to keep up with inflation or to one day pass it on to family – may seem more vulnerable.
With such individuals it can be important to diversify, and to dial down risk in some cases. As alluded to earlier it can also be helpful to have some cash on the side to ensure they do not need to dip into a portfolio that has fallen and crystallise any losses.
While dividend-paying companies and many equity income funds have held up relatively well in the past year, many other assets that are either seen as defensive or as income plays have suffered a fall, from the fierce fixed income sell-off to the problems in areas such as infrastructure. For now, there are few places to hide if you are fully invested.
As Antony Webb, deputy head of model portfolios at Quilter Cheviot, notes, it remains of utmost importance not to confuse capacity for loss with risk tolerance.
“Capacity for loss generally refers to the impact that a capital loss would have on the client’s standard of living,” he says.
“It can be described as whether they can afford to take risks. A gambler may have a high appetite for risk – whether or not they have a gambling problem depends on the impact of any losses on their lifestyle ie their capacity for loss.”
david.baxter@ft.com
Is it possible to construct a cautious portfolio right now?
One of the touchstones of portfolio construction in recent decades has been the premise that bonds and equities are inversely correlated.
If that is the case, then creating a portfolio with caution in mind is relatively easy, as one can increase the respective bond or equity portfolio allocations depending on the prevailing economic conditions.
Ben Seager-Scott, head of multi-asset funds at Evelyn Partners, says the key is that there are two types of negative shocks that can impact a portfolio: an inflation shock or a growth shock.
An inflation shock probably describes the scenario faced by investors since Russia invaded Ukraine. According to Seager-Scott, in such a situation, the logical action is to increase equity allocations and reduce bonds, as the fixed income would be less attractive.
In circumstances where a growth shock is the biggest worry, investors would likely sell equities and buy bonds, as bond prices would be expected to rise as investors place a higher value on the safety of the income.
The equity market has been forked all year long which should continue
The problem right now, says Seager-Scott, is that while the inflation shock is happening (so bonds are not performing), a growth shock appears imminent, so equities are also under performing.
Giles Parkinson, portfolio manager at Close Brothers Asset Management, says the dilemma tends to occur when inflation rises above 4 per cent, as this is the level when equity investors begin to worry about the health of the economy, while bond investors are sitting on losses.
Michel Perera, chief investment officer at Canaccord Genuity Wealth Management, says: “Paradoxically, it is easier today to create a cautious asset allocation than one year ago. The reason is simply that bond yields have surged. The old TINA ('there is no alternative' – to equities) is now TARA ('there are real alternatives').
"The higher yields not only make government bonds less unattractive but have thrown off extraordinary value on corporate bonds. In so doing, some equity risk can be replaced by credit risk to reduce volatility, provided the underlying credits are well-researched and long durations are avoided.
"In addition, the equity market has been forked all year long which should continue, with growth stocks going in one direction and energy and defensive sectors in the other, depending on market expectations for Fed policy."
Parkinson says the situation facing investors now is similar to that which occurred in the 1970s. In that environment, he says equity investors will need to focus more on the valuations at which companies trade, and less on whether a stock is a 'good company', because higher rates mean valuations will generally fall.
It is more difficult than ever to run a cautious portfolio. But I think the key is to be more nimble and broaden the range of asset classes you look at
He says it is imperative in the current climate that bond allocations are kept short duration, as they are less sensitive to interest rate movements.
Despite his background being as an equity investor, Parkinson is actually more excited about the opportunities he sees in bond markets right now, specifically in the investment-grade segment, where yields can be as high as 8 per cent.
More broadly, he says the best portfolio right now is “the cheapest one”, as it is not time to take risks on the economic outlook.
Fahad Hassan, chief investment officer at Albermarle Street Partners, says a curiosity of the markets this year has been that assets that would usually be regarded as cautious have actually underperformed relative to the assets that are traditionally viewed as higher risk.
In terms of remedies available to advisers he says: “Asset allocators can utilise lower duration bond holdings, allocation to safe haven currencies such as the US dollar, and low volatility equity allocations to sectors such as utilities and healthcare. While these allocations cannot insulate portfolios entirely from the consequences of rising real rates, they can help build more resilient low-risk portfolios.”
Andrew Keegan, head of wealth EMEA at BlackRock, says: “It is more difficult than ever to run a cautious portfolio. But I think the key is to be more nimble and broaden the range of asset classes you look at to include commodities, gold and other alternatives but also cash.
"And you might do that by diversifying away from fixed income, although some bonds look more attractive now than they have for a while."
Alex Funk, who runs the model portfolio service at Schroders Investment Management, is another who is keen on increased exposure to alternative assets in the current climate, telling FTAdviser he views hedge fund type strategies as being capable of offering diversification against the series of risks that dominate the market right now.
Reducing interest rate risk (duration) has been the key call this year
Antony Webb, deputy head of model portfolios at Quilter Cheviot, says the firm can use either active or passive funds in its model portfolios, but has a strong preference for active funds at a time of heightened market stress.
He adds: “[The] ability to be active within asset classes is key – activity in these areas has been key this year to managing risk. An active approach is key when markets rotate. Passive investment vehicles tend to have structural exposure to asset classes such as equities and bonds, and investors will experience the index return of each of those assets.
"Reducing interest rate risk (duration) has been the key call this year for low-risk clients who have bond exposure and are experiencing capital losses. This is an active decision that cannot be taken in many passive vehicles."
Peter Wasko, senior portfolio manager at Copia Capital, does allocate to alternatives, and has increased the allocation in recent months, but says the price declines in both bonds and equities this year mean that, even for a client with a cautious risk profile, there are opportunities in those conventional markets.
Chris Fleming, investment director at consultancy firm Square Mile, is finding more opportunities in absolute return funds, but says the long-term strategic allocation to bonds in cautious portfolios may be challenged because, while there are a huge quantity and range of bonds in the market, many asset allocation frameworks focus on the UK gilt index, which has been acutely volatile this year.
david.thorpe@ft.com
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