Asset Allocation: Just got bigger

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Euan G Munro discusses structural changes to the role of asset allocator and asks whether they should be empowered with further responsibilites within the investment process

The role of the asset allocator has changed significantly over the past decade or so, but not in the way that some perhaps assume.

I do not imagine, for example, that in recent history as investors bolted together their multi-asset portfolios they were trying to do anything other than engineer an absolute return. Of course they were. However, their portfolios were in practice substantially dependent on the long-term rewards associated with the equity market.

The rationale seemed well founded: after all, it is easier to deal with uncertainty and volatility if there is a clear long-term reward, and in the last 30 or so years of the twentieth century investors perhaps felt that equity markets provided exactly this kind of dynamic. This encouraged many investors to skew their investment strategy towards harnessing the equity risk premium. Even yet, traditional ‘balanced' funds typically run with an equity allocation of greater than 60%, a strategy destined to succeed depends almost exclusively on the delivery of strong equity returns.

The role of the asset allocator in this world was to take some small tactical positions around this equity-heavy policy position and add some icing to the cake. However, the overall confection rapidly loses its appeal if equity markets fail to deliver a decent return. Can we not do something less risky than simply collecting the long-term equity risk premium?

The argument for a greater role for active multi-asset fund management has also been underlined by the increasingly volatile and fickle nature of markets. Over the same 10-year period where we have seen the developed equity markets trade sideways we have had episodes of interest in technology, commodities, real estate, credit, emerging market equities and debt. The speed at which the market appears to change its mind about the desirable asset classes, and the amplitude of the moves in prices has created plenty of opportunity for asset allocators to add substantial value to investment portfolios.

This has created an environment where good asset allocators may step into a bigger role. If we accept this challenge, we are in a position where in the event of failure there is no acceptable excuse, no benchmark to hide behind, everything is our fault.

In response to this, some multi-asset managers broadened the range of assets that they invest in to embrace commodities, infrastructure, insurance linked securities, and so on. This has spawned a new generation of balanced fund, often dubbed ‘diversified growth'. This can certainly be seen as an advance on an equity dominated balanced fund model, but it is still fair to say that diversified growth investing received a bloody nose in 2008, when it appeared that the reward from diversification was very scant.

Perhaps the disappointment arose because too much was expected of diversification between growth assets. Should we be surprised that assets with a direct linkage to economic expansion all do badly when the economy contracts?

Our customers want to see their portfolios grow year after year with as little volatility as possible. In particular, they find it unacceptable to be losing money on their investment portfolios during recessions, just when they may need their savings. So we worked on an absolute return approach, rather than diversified growth.

So how should you do multi-asset absolute return investing? First you have to extinguish over-confidence. An investment process that relies on getting your macro-economic view precisely right is very arrogant and likely to disappoint. Far better to try and think about a wide range of plausible futures and create as high a probability as possible of delivering the target in as many of them as possible.

We do embrace the free lunch offered by diversification. Simply exposing the fund to a variety of rewarding strategies provides the expectation of a positive return with less risk than any single asset class fund can offer. However, because we have an absolute return approach we add strategies that we expect to reward strongly during periods of economic distress.

The process must try and exclude bias in the idea flow. In our view a team approach is best, providing a more effective challenge to the stock of investment ideas than if one or two individuals take an insular approach. It is also healthy to observe ideas being justified by varying lines of argument such as momentum, value or quantitative analysis, as this means that the portfolio will not have a strong style bias.

Differentiation of investment views by time frame can be important. In our approach we take long-term views, and fish in less crowded pools for ideas. A related point is that it can be useful to take investment risk in a totally different context from the average investor in that particular risk category. Investors are typically crowded into silos and restricted by their mandates to view risk through a particular prism. For example, the average investor taking an interest rate duration position will be a bond manager with a small risk limit and little opportunity to diversify away this risk. The result is that bond managers often need to take repeated, small, short-term directional bets and get the direction of interest rate moves right more than 50% of the time. However, a multi-asset manager can take a duration position on a long-term basis, relax and enjoy the yield available, so long as there are some other positions that will do well should interest rates unexpectedly rise. This could be perhaps a pro-growth currency, a long inflation position or equity exposure. The point is that duration in the context of the right balancing position ceases to be frightening and can actually reduce portfolio risk - in effect becoming like owning a put option on risk assets, but getting paid to do so.

We believe that skilled multi-asset managers, backed with the right level of risk expertise are best placed to assist. But taking responsibility for the overall success of a multi-asset portfolio represents a much bigger job for asset allocators, with the quantum of pure risk we will be answerable for increasing tenfold, compared with our old task of tactical asset allocation alpha.

Euan G Munro is head of multi-asset investing & fixed interest, Standard Life Investments


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