By Jayson Forrest - Managing Editor - IMAP Perspectives
Asset allocation: Evolution not revolution
The biggest contributor to portfolio outcomes is asset allocation. Richard Rauch (First Sentier Investors), Michael Karagianis (JANA Investment Advisers), Alex Cathcart (Drummond Capital Partners), Jesse Imer (Mason Stevens) and Jerome Lander (WealthLander) discuss their optimal approach to asset allocation, particularly when building portfolios in a challenging environment.
There are many common mistakes advisers and investors make when building investment portfolios. Some of these include: frequently changing the asset allocation; using a set-and-forget strategy; having unrealistic return expectations; and failing to invest or under invest in assets when conditions are favourable.
Ask Richard Rauch CFA - Investment Director, Fixed Income and Multi-Asset Solutions at First Sentier Investors - what the biggest mistakes clients make with their asset allocation framework, and he says it’s taking a rear-view mirror approach to investing.
“The biggest challenge is convincing clients that what worked in investment markets over the last 10, 20 or 30 years, may not work in the next five or 10 years,” he says.
It’s a similar view shared by Michael Karagianis - Head of NFP and Retail Partnerships at JANA Investment Advisers - who adds that advisers often interpret different styles of investing, like Dynamic Asset Allocation, as an invitation to make as many asset allocation changes as possible within a portfolio. And invariably, he says, while advisers get some changes right, JANA’s observations is that they tend to get more of these changes wrong than right.
“The best asset allocation calls are the ones that are held with high conviction and are relatively infrequent. These calls may be one or two years, but they are significant and add value to the portfolio. They might be for the purpose of reducing risk or boosting returns or a combination of both,” Michael says.
“However, frequent asset allocation changes just adds noise to a portfolio. Are you making decisions simply because you feel compelled to do something within a portfolio?,” he asks. “You don’t need to be active for the sake of being active. In fact, if you trace back the positive or negative impact of your decisions, quite often, you’ll find you’re better off not doing anything at all. Don’t try and overachieve by doing too much within a portfolio.”
While side-stepping the active vs passive debate, Richard believes that within a multi-asset portfolio, advisers actually need to be more dynamic and liquid with their asset allocation, and often that means holding the liquid exposures in passive baskets.
“Active management is fairly cyclical,” says Richard. “There are long periods of time where active management does well, and long periods of time when it doesn’t. If managers can deliver a positive net outcome to clients, after fees, then they’re getting good value for that.”
Richard Rauch CFA - First Sentier Investors;
Michael Karagianis - JANA Investment Advisers
Alex Cathcart CFA - Drummond Capital Partners
Jesse Imer - Mason Stevens
Jerome Lander - WealthLander
Opportunities in challenges
Asset allocation is challenging at the best of times, and never more so than in the current low interest rate, low return environment. But while there are challenges, there are also opportunities, particularly for wholesale investors, says Jerome Lander - Chief Investment Officer at WealthLander.
For Jerome, wholesale clients who do not need daily liquidity, shouldn’t be put in a retail type solution. “That’s because the solutions available to wholesale clients are superior to many of the solutions available to retail clients who require daily liquidity. These wholesale solutions have better quality sources of alpha and a wider spread of asset classes available.”
Importantly, Jerome encourages advisers to stop thinking local and consider global opportunities when investing, particularly with boutique managers.
“Don’t be sold by what’s in Australia. Look more broadly and globally in terms of finding terrific active managers, of which there are many,” says Jerome.
Jesse Imer - a Multi-Asset Investment Strategist at Mason Stevens - agrees: “By accessing products globally, then we don’t have to worry about the currency volatility by using active managers across managed accounts, managed funds or ETFs. There are ample opportunities for Australian-based investors to invest globally. For example, countries like Spain or France might have ideal equity markets to invest into, but how many Australians are invested in Spanish or French equities. Probably none.
“And it’s the same when you come to Japan. We know that Japan is quite a large value market because of its wider dispersion of industry sectors, compared to Australia. But how many investors have increased their allocation, or even have any allocation, to Japan this year, when we’ve seen this cyclical rotation from growth into value stocks?
“So, knowing a bit more about global asset allocations and taking advantage of that is definitely going to be advantageous going forward.”
For Alex Cathcart CFA - a Portfolio Manager at Drummond Capital Partners - the greatest opportunity he identifies around asset allocation is with innovation and technology. “Managed accounts facilitates greater efficiency and time-savings for advisers, by enabling them to step away from the day-to-day investment management, and outsourcing that process to professional managers.”
Whereas for Richard, he believes ‘credit’ is a definite opportunity for investors in the current environment. He prefers global assets, which look more attractive than Aussie assets.
“The Aussie banks don’t want your money or need your money right now, and hence, they are dominating the market and the margins you can get. So, in Australia, from short-dated credit to medium-dated credit to longer-dated credit, it’s quite a bit less than you would have got historically,” he says. “However, we do like floating-rate credit, because then you can take longer-dated holdings, hedging the interest rate risk out.”
Assets as diversifiers
Traditionally, when building robust investment portfolios, advisers tend to lean towards going overweight with equities. However, for Alex, his favourite asset class for bringing greater diversification to a portfolio is currently bonds.
“It’s always going to be bonds, until we hit a point where the inflation premium suddenly returns. But I don’t think we’re there yet. And while inflation has become a concern because of massive fiscal stimulus on top of fiscal stimulus, at least for now - unless there is an equity market correction - we still expect bonds to provide some diversification,” he says.
Alex also points to the low correlation of alternatives, adding that over the long-term, they’ll generally reduce portfolio volatility. In addition, he says illiquid assets are also worth consideration when thinking about portfolio diversification.
Jesse also likes fixed income as a diversifying asset, saying there is no real alternative that provides the same level of liquidity.
“We believe you have to be a lot more active in fixed income and buying absolute return fixed income managers, rather than having passive exposure to, say, an AusBond composite, where you’re going to be long duration,” he says.
When considering the various sectors that investors should consider having exposure to within their equity allocations on a longer term basis, Alex believes it’s hard to ignore the large U.S. tech companies. He says the U.S. regulatory environment is currently favourable for these companies, which continues to attract the world’s leading technology innovators and start-ups.
On a short-term time horizon, Jesse is still looking for value, as he does think yields will move a little higher. However, he concedes yields will drop back down over the longer term, as markets enter a low growth environment, where the extent of debt in the market is going to be prohibitive to future growth.
“Over the long-term, we’re more focused on growth and quality in the equity markets. Momentum is gathering behind ESG mandates, and ESG tends to invest in higher quality factor companies. This means there will be a drive behind value factors, which will provide performance because of fund flows. As such, market capitalisation should grow over a longer period of time.”
While Alex accepts that ESG is a growing part of the market, he warns about the extent of ‘greenwashing’ by fund managers within the market. But despite this, he accepts there will increasingly be more integration of ESG within investment processes.
“I don’t necessarily believe you need to have a separate ESG product, unless your end investors demand it. But I absolutely do think you can’t ignore ESG in your investment process, just like you can’t ignore valuations or an investment outlook,” he says.
Improving portfolio performance
When building diversified portfolios, there is a common perception by investors that diversification can lead to lower performance. And while it’s an observation that Alex accepts, he doesn’t believe it has to be the case with diversified strategies, even in a low growth environment.
He explains: “Obviously, reducing fees are a risk-free way of increasing returns, but more importantly, don’t be static when managing your portfolios. You need to be active, particularly in a low growth environment.
“A current expected return of 5-6 per cent, which is two-thirds of what it has been over the last 20 years, means there is capacity to generate returns on top of that from an asset allocation and active manager perspective.”
To do this, Alex suggests that boutique advice practices have the capacity to invest in smaller, more nimble managers, compared to a pension fund that can’t afford to wear any tracking error.
Jesse agrees, adding that with continuing market uncertainty, there is a definite need for liquidity in portfolios going forward. He also expects to see a resurgence of active management from passive, where the market has moved more towards over the last decade.
Duration risk within portfolios
And what about portfolio protection? How should advisers be using asset allocation to protect investment portfolios, while protecting against the risk of higher inflation?
Michael believes that if the specific risk that advisers are guarding against is inflation within a portfolio, then advisers need to consider their overall exposure to growth assets.
“The collapse in bond rates has been a major driver in equity beta. So, if you were to assume that there was a breakout in inflation and a rise in yield curves, then that would have to be a negative factor for equity markets.
“So, you need to have a firm view as to the appropriate amount of overall risk within the portfolio, and perhaps become more defensive by nature. This means looking for asset classes that have a direct exposure to rising inflation, like inflation-linked bonds. Even infrastructure, where revenue flows are directly linked or indexed to inflationary pressures, would be potentially positive within portfolios as well.”
He adds that within fixed income, be very careful about duration exposure.
“In that environment, where yield curves rise, short rates are going to rise as well, but the capital loss you will get from longer-dated debt is going to be greater. So, be careful about the duration risk you have within portfolios.”
To hedge against portfolio risk, Michael suggests considering more international currency exposure within a portfolio.
“Again, that seems counterintuitive because the Aussie dollar often does well in a rising economic environment. However, if we get to a point where equity markets have a substantial correction, one of the great defensive mechanisms within a portfolio is to hold more foreign currency exposure. And unhedged global equities actually do much better in an inflationary environment than global equities on a hedged basis, which also provides defensiveness for a portfolio.”
However, Richard believes it’s unlikely we will reach a ‘runaway’ inflation scenario, adding that bond markets are not pricing in ‘runaway’ inflation. As an inflation hedge, First Sentier Investors uses commodities, like gold, in its multi-asset portfolios.
Ask Richard if he believes the way advisers asset allocate will remain the same or change over the next five or 10 years, and he is firmly of the opinion that advisers will go where the return profile is going, “and that’s going to be more goals-based”.
“It’s about understanding what your true liabilities are and ensuring that every decision you make on the asset side, ties in to those liabilities. I believe that will be the direction we go, because when we look in the rear-view mirror, the traditional fixed income 60/40 split is not going to look too pretty,” says Richard.
However, it’s a different view held by Michael who is predicting “evolution, not revolution” in asset allocation, unless there is a major event affecting markets, like a collapse in markets as a result of a liquidity exit strategy by central banks.
“I believe the philosophy of Strategic Asset Allocation (SAA) and tilting portfolios to the concept of what SAA actually is, will change over time. But the philosophy of how we go about building portfolios, unless something radically happens within markets, will continue to evolve naturally over time,” Michael says
Richard Rauch CFA is the Investment Director, Fixed Income and Multi-Asset Solutions at First Sentier Investors; (First Sentier Investors),
Michael Karagianis is the Head of NFP and Retail Partnerships at JANA Investment Advisers;
Alex Cathcart CFA is a Portfolio Manager at Drummond Capital Partners;
Jesse Imer is a Multi-Asset Investment Strategist at Mason Stevens; and
Jerome Lander is the Chief Investment Officer at WealthLander. They spoke as part of an IMAP webinar specialist webinar series on asset allocation.
The webinars were moderated by Jerome Lander.