Asset Allocation: The 60/40 question
Joseph Mariathasan asks how multi-asset managers are seeking to prove their worth in a low-return, high-correlation world, when a 60/40 equity/bond portfolio looks hard to beat
At a glance
• How can multi-asset strategies beat a 60/40 equities/bonds portfolio in future?
• Pure beta is no longer enough.
• Equity allocations vary dramatically in multi-asset strategies.
• Investors need to be selective in emerging markets.
• Managers are moving away from traditional asset classes.
Investors would have done well during the last 30 years relying on a simple asset allocation strategy of 60% equities and 40% bonds. Marino Valensise, head of Barings’ multi-asset group, points out that such a strategy would have generated about 9% annually with a volatility of 8.5-9%, giving an information ratio of 1. With annual US inflation averaging 3% for the period, it would have provided a handsome return. But the question for any multi-asset strategy is what will the next 10 years look like?
The last 30 years have experienced returns that history will judge as above-trend, argues Andy Ford, investment director of Standard Life Investments (SLI). This has been the result of a combination of low inflation, low interest rates and declining tax rates, together with the opening up of emerging markets and the integration of global supply chains. But equities are likely to produce lower returns in the future, and with negative bond yields on 40% of euro-zone sovereign debt and some corporates even issuing bonds at negative yields, prospects for bonds look tough. Over the next decade, no-one expects a simple 60/40 equities/bond portfolio allocation to produce much more than 2.5% to 3% per annum.
For multi-asset managers, the prospective returns from such a strategy are certainly unattractive. The genre of diversified growth multi-asset funds, which has become popular in the UK in the last 10 years, typically has a LIBOR or inflation-plus 4-5% return target. Seeking to achieve better returns than from a 60/40 asset allocation, Valensise argues, has two implications: first, pure beta is not enough, so investors would have to adopt active approaches in both equities and fixed income; second, strategies need to be dynamic, which requires some element of timing markets.
Different roads to Rome
Despite their comparable return targets, multi-asset strategies vary dramatically in how they achieve them – this can be seen by looking at the equity allocations. Standard Life has the lowest allocation to equities that it has ever had in its GARS fund, says Ford. In contrast, Barings, which runs four main multi-asset strategies – income, targeted return, absolute return and balanced – has a 40% exposure to equities.
Aviva Investors, which launched its Aviva Investors Multi-Asset Strategy (AIMS) fund range in 2014, has about a 30% allocation, primarily for dividends, although it hedges some risk using futures, according to Nick Samouilhan, senior fund manager.
Taking dynamic positions means having strong views on specific markets. One popular approach is mean reversion; the idea that valuations of asset classes would always trend back to a long-term mean. GMO, a practitioner of this idea, forecasts negative returns, or close to zero returns, on a seven-year period for all asset classes, apart from emerging market equities and timber on this basis, with US large-cap equities and global bonds the least attractive. Others would argue that mean reversion is misguided. Not only can the time periods be much longer than acceptable, but structural changes can create a shift towards a new mean.
New York-based PineBridge Investments, which has $14bn (€12.5bn) in multi-asset strategies, has Japanese equities as its highest-conviction position, according to portfolio manager Hani Redha. “It is a good example of where we think mean reversion misses the whole point of what is going on,” Redha says. The firm says a revolution in corporate governance is happening in Japan, with companies becoming more shareholder friendly. This is causing a structural change to long-term mean valuations.
The recently created JPX 400 index, for example, is based on selecting stocks with shareholder-friendly characteristics, for instance companies with high returns on equity relative to others in their sector. Both the Bank of Japan through its quantitative easing programme and the Government Pension Investment Fund, one of the largest funds in the world, are increasing equity exposures through ETFs based on this index, says Redha.
“If traditional long-only asset classes are not going to deliver the returns that multi-strategy funds are explicitly promising their investors, they will have no choice but to use more complex strategies that can at times seem like an overlap with hedge funds”
Aviva Investors, whose AIMS range of funds had AUM of £6.2bn (€7bn) in June, is also bullish on Japanese equities, with exposure through call options. Such positions are not universal, however. Standard Life sees more opportunity in European equities, saying operational gearing benefits have not yet been adequately factored into prices. Aviva Investors favours both Japan and Europe, along with emerging markets for its 30% exposure to global equities.
Emerging markets are looking more attractive. Barings was out of emerging markets for a long time but went back in during April. This was initially into bonds, says Sonja Laud, investment director, who explains that the attraction was the benign dollar rather than just the improvement in emerging markets. “When dollar appreciation stopped, we started to see emerging markets outperform,” she says. “Local currency bonds are the main beneficiary as they benefit not only from the high yield but the currency carry as well.”
Barings also subsequently moved into global emerging-market equities, with returns mainly coming from Latin America and Eastern Europe. Asia has not rallied so greatly, suggesting that it may catch up at some point in the future. Pinebridge is also selective, according to Redha. The firm has equity exposures to just three countries – Mexico, India and Indonesia – along with local currency debt in Brazil and Indonesia. Redha also likes Panama for hard currency debt, with a number of positive factors including the expansion of the Panama Canal.
Aviva Investors, in contrast, prefers the debt markets in South Africa and Mexico. But as Redha says, for many investors, shorting the Mexican peso has become the most popular way to hedge the risk of Donald Trump’s becoming the next president of the US, since Mexico is the main beneficiary of the North American Free Trade Agreement, with a large industrial base built on exports to the US. Positioning for a possible Trump presidency is an increasing concern. SLI has a number of positions that would likely benefit from a Trump victory, such as short positions on Asian currencies given the likely negative impact on trade for cyclical countries such as Korea and Singapore.
If traditional long-only asset classes are not going to deliver the returns that multi-strategy funds are explicitly promising their investors, they will have no choice but to use more complex strategies that can at times seem like an overlap with hedge funds.
The biggest difference, apart from fees, may actually just be one of duration. SLI typically invests for about three years, says Ford. Barings, for example, invests in a variety of highly specific themes and styles when it comes to equities. These include mini-baskets of lithium battery technology stocks, European real estate investment trusts (REITs) and Japanese banks. The objective, says Valensise, is to get equity-like returns for the fund with less volatility. This can be achieved by incorporating other asset classes when valuations look attractive. The return on US high yield, for example, has been similar to that on the S&P 500 in recent years, but with lower volatility. It also has the advantage of delivering a high-running yield of 6.5%.
Barings controls volatility by taking active positions in currency. The yen, for example, has been inversely correlated with Japanese equities over the past few years. The firm has taken much higher currency positions in the last two or three years, says Valensise. “We went into the Brexit referendum 30% underweight sterling and went to 40% underweighting the day after.”
Moving away from traditional asset classes can mean diversifying risk exposures across a wide range of positions. SLI’s GARS fund had a 25% nominal exposure to credit in the form of US high yield, US investment grade and European and UK investment grade, where it sees sense in moving up the capital stricture. Its 12% equity exposure is mainly Europe (9% including the UK) with just 3% in the US. It also has relative-value trades, such as the S&P 500 versus the Russell 2000, or tech stocks versus small cap. At one stage, Standard Life held a position of European banks versus European insurance companies. However, that has been reduced as the firm sees European banks acquiring more of the characteristics of utilities.
Currency is treated as a separate decision, with trades such as US dollar versus Singapore dollar, and Korean won versus the euro, Indian rupee versus Swiss franc and Korean won. It also changed its view on duration, moving from a net short position of 0.3 years at the beginning of this year to a net long position of 1.8 years by September. Credit exposure has increased as the firm believes that over the next 18 months the rise in interest rates will be less steep than previously thought. In this environment, it has also put on positions in US and European REITs.
For investors, the prospect of low returns from a traditional 60/40 equity/bonds allocation raises considerable challenges. Perhaps the biggest may be deciding which of the multi-asset strategies is most likely to do better.