Hindsight, according to traditional wisdom, is a beneficial thing. It could be argued, there are few fields of endeavour in which the ability to learn from past experiences and errors could offer greater benefits than in the field of managing investments. Yet the principal problem with this line of thinking, when applied to managing investments, is that no two economic cycles are identical, meaning that lessons learned in one cycle can often be of limited use in a future cycle.
Furthermore, when looking at historic patterns of investor behaviour, it quickly becomes apparent that investors have an uncanny ability to overcompensate for their previous errors rather than adapt their strategies for uncertain future outcomes. The danger of this retrospective approach is that it lacks the flexibility necessary to adapt to evolving capital market conditions such that investors often fail to mitigate the adverse effects on wealth associated with volatile market environments.
Chasing an equity risk premium that never materialised
Superficially, the shape of the investment landscape in the first decade of the 21st Century ended much as it began; it was a scene of widespread pension deficits – despite vast sums being spent by plan sponsors – and general disillusionment with equities as an asset class. During this period, which incorporated both the bursting of the technology, media and telecoms (TMT) bubble and the global financial crisis, the key to a successful investment strategy was to make the right decisions on when to hold and when to avoid equity market risk. Alas, relatively few investors demonstrated the nimbleness necessary to limit the downside of exposure to equities
The risk now, perhaps, is that many investors are in danger of making a remarkably similar mistake again. In the scenario in which investors now find themselves, the effect
of repeating earlier failures to allocate effectively between major asset classes could become particularly expensive, as the opportunity to recoup poor performance
in the “lower return” world is likely to be severely restricted. Investors entered the last decade with a high exposure to equities, mainly because of the euphoria that had accompanied equity investments in the preceding decade. However, following the bursting of the dotcom and credit bubbles, and the steep equity market declines that ensued, many investors ended the period feeling bruised and highly skeptical about the presence of equity risk premium.
Consequently, the next decade looks set to be one in which investors, disillusioned with equities, eschew the asset class in favour of others, where historic performance has been superior. Amid rising pessimism towards equities, increasing emphasis is being placed by investors, collectively, on fixed income securities as a way of managing liabilities and to generate returns from income. However, with real interest rates at record lows in certain developed economies, investors are likely to receive little or no compensation for holding developed government bonds. This in turn will constrain the potential of spread assets such as corporate bonds, whose performance is related to the performance of government bonds.
Despite the current, volatile market scenario, there is already substantial evidence to suggest a “herd mentality” is developing, with fixed income assets attracting large inflows, while equities appear to be less favoured. It is precisely this kind of collective behaviour that can lead to the creation of asset bubbles. Bearing this in mind, it might be argued that “shutting the door” on equities at this stage may well be an error. Hindsight will tell but will be of little use to those investors who follow the herd.
Alternatives come to the rescue…or do they?
Having earlier decided the equity risk premium had proved itself too great a gamble, many investors have been quick to drop equity exposure in favour of alternative investments such as hedge funds, property, commodities and private equity. Many of these investments have also disappointed. However, the question remains: does the continuing promise of bond markets and alternatives mean investors will never again see any attraction in the equity risk premium?
If they are to avoid making the mistake of having an inappropriate asset allocation
at different stages of the market cycle, investors must pay greater attention to a range of considerations. Among the most notable of these are liquidity, or the lack of it, and the danger of purchasing overpriced exposure to market risk masquerading as excess returns – a criticism leveled at some types of hedge funds. However, of greater importance still is the risk investors continue to apply an allocation that is too static or inert. In the current environment, for example, the danger for many portfolios appears to be investors will maintain too large an exposure to bond markets for too long. Markets have proved themselves to be dynamic environments, which is why it is so important asset allocation be dynamic, moving holdings between income and growth assets freely, as anticipated market conditions dictate. After all, reducing portfolio risk when the opportunity to make an attractive return is very small makes absolute sense. This is why we believe aligning risk exposure and opportunity on a dynamic basis should be a non-negotiable feature of any approach to asset allocation. In other words, there is no such thing as an effective passive approach to asset allocation.
What does a dynamic asset allocation look like?
Significant returns can be made by “timing” markets correctly. However, in reality timing markets consistently and accurately is widely considered to be impossible. Nevertheless, investors need to be nimble and willing, even radical, when they reassess their investments, just as fundamentals can change radically over the course of a market cycle.
In practical terms, this can mean relatively significant swings into and out of underlying investments in a portfolio, albeit while assessing with great care the costs of doing so relative to its benefits. We believe, to accept this necessity is to acknowledge that following a policy allocation benchmark is far too restrictive – the investment equivalent of wearing a straightjacket.
It prevents allocators from taking the required evasive action when necessary and from taking advantage of attractive opportunities when they present themselves.
Avoiding uncompensated market risk, while seeking superior opportunities
Allocating assets effectively is not a task that can be divided between many different individuals or organisations; it is essential to charge a single individual or organisation with overall responsibility for the mandate of applying a dynamic asset allocation approach.
