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Asset allocation: favouring durability and defensiveness

Last year’s portfolios failed to go off with a bang, but we are retaining some protective elements for 2019
Asset allocation: favouring durability and defensiveness

Reviewing the performance of our tactical asset allocation (TAA) portfolios from last year, was very much like opening a disappointing Christmas present. Or since I picked them, more like sheepishly watching someone else open the rubbish present you got them. Total returns of both the general and multi-factor portfolios were flat net of fees. In real terms, they are slightly down over the year.

After an excellent 2017, the portfolios were positioned defensively in anticipation of a more difficult year for the world economy, so the weak performance was not unexpected. Both portfolios had a high allocation to cash which, given UK rates are still only 0.75 per cent following the 25 basis point rise in August, was always a risk trade-off against the possibility of drawdown if equities had a bad year.

Normally, a fully invested portfolio would balance muted expectations for shares with a higher allocation to bonds. Concerns about bonds – chiefly the sensitivity of their greatly inflated prices to tightening interest rates – prompted us to take more of a barbell approach last year. The portfolios stayed heavily exposed to shares – 62.5 per cent for the multi-factor and 52.5 per cent for the general tactical asset allocation – with cash offsetting this risk. As it happened, the performance of our bond funds was similar to cash, so this tactical risk-off approach didn’t cost us.

As it turns out, the biggest mistake was underweighting US equities, which in the first half of 2018 hit new record highs. The market has re-set somewhat since the autumn, but over most of the year the US outperformed once again. The year’s major dud was the eurozone, with our Eurostoxx exchange traded fund (ETF) losing nearly 9 per cent, vindicating our decision to reduce exposure from 2017 levels. Japanese equities fared better, but were still flat over 12 months.

In the UK, the FTSE 100 started the year brightly, dipped and then, despite steadying after autumn’s mini sell-off, has handed back 2018’s gains. The FTSE 250, where companies typically are more exposed to sentiment towards the UK economy, has had a poor year – the ETF we used for the General TAA lost nearly 3 per cent.  

Of the two portfolios, the multi-factor (MF) strategy did slightly better, but once its higher charges are factored in, they were almost identical. A slightly lower standard deviation of returns flatters MF on a risk-adjusted basis. The MF Sharpe ratio (which we calculated as its return in excess of the UK Gilts ETF divided by its standard deviation) for last year was 0.43, versus 0.3 for general TAA, but at the low absolute levels of volatility, this difference can be taken with a pinch of salt. In any case, recent levels of volatility (which have been extraordinarily low in patches) are not an adequate measure to use as a proxy for risk.

The reason for MF’s better absolute returns is its geographical focus – with proportionately greater allocations to US equities. The best-performing fund in either portfolio was the market-cap-weighted S&P 500 ETF, but it was only 7.5 per cent of general TAA. The factor ETFs in the MF portfolio track indices created by making tilts from the market-cap-weighted MSCI World, which is roughly half US stocks. As three factor ETFs made up 30 per cent of MF, this portfolio naturally had a higher weighting in 2018’s best regional equity allocation.

With this in mind, factor-driven strategies were disappointing. Arguably the returns came from good old-fashioned US market beta, and not so called ‘smart beta’ due to selection algorithms. Whereas the Vanguard S&P 500 ETF (VUSA) made over 14 per cent, the ETF tracking MSCI Global Quality (iShares World Quality (IWQU)) made 5.3 per cent and the fund tracking MSCI Global Minimum Volatility (iShares World Minimum Volatility (MVOL)) made 7.1 per cent. Of course, these are more geographically diverse so it’s not a direct comparison, but in either index the returns came from US companies which had a decent weighting in the S&P 500 anyway. Of course, there is also the question of charges, with the US main market ETFs available for as little as 8 basis points – a fraction of what’s charged for smart beta products.

The weakest performing global factor ETF was value, iShares World Value (IWVL), which, following on from stellar returns in 2017, lost 1.1 per cent as growth stocks shone once again. The very worst factor ETF, however, was the UK dividend stocks fund, SPDR UK Dividend Aristocrats (UKDV), which lost 6.5 per cent. This is a strategy we can compare fairly to our holding in a market-cap-weighted index. The FTSE 100 ETF, iShares FTSE 100 (ISF), by contrast, has made 0.47 per cent, which although far from impressive, does call into question the efficacy of smart beta investing in what is historically more of a stockpicker’s market than the US.

 

Thoughts and tweaks for 2019

Two main areas of concern in the past year will continue to be important issues for investors in 2019, namely the pace and impact of monetary policy normalisation and the potential for trade disputes to de-rail growth. On the latter point, the apparent verbal breakthrough made between President Trump and China’s Premier Xi Jinping at the G20 meeting, offers a glimmer of hope that a trade war between the world’s two biggest economies can be averted.

Nothing has been formalised, but hints of removal of some Chinese tariffs on US car exports could allow President Trump to delay the escalation of tariffs on Chinese goods without losing face. This is a story that will continue to unfurl in 2019 (and beyond) but any signs of pragmatism from both sides will be welcomed by equity investors in the short term. Any optimism needs to be tempered, however, by an appreciation that the Sino-US rivalry runs deeper than a simple trade dispute. Forced technology transfer from US to Chinese companies may be the red line for both powers that triggers a re-escalation.

Closer to home, the UK has been in the departure lounge of the European Union (EU) for nearly two years since Article 50 was triggered, and boarding calls are being made. To extend that popular metaphor, the final exit is shaping up to be about as orderly as a drunk arguing about getting on a flight. Regardless which side of the Brexit divide you sit on, continued uncertainty and wrangling will weigh on the UK economy.

Even if global trade tensions are reduced to a simmer, there are ongoing concerns about the direction of monetary policy by major central banks. In 2018, the US Federal Reserve hiked the target federal funds rate three times, with the upper bound of the range now at 2.25 per cent (a fourth increase to 2.5 per cent is widely anticipated in December). This has seen yields on US Treasury bonds rise, with the benchmark 10-year note at 2.97 per cent at the time of writing. Prices adjusting to maintain the equity premium has been a factor in volatility in US stocks since September and there is a knock-on effect for other asset classes too.

In Europe, European Central Bank (ECB) Chair Mario Draghi has signalled the end of quantitative easing (QE), but remains dovish on rates. Mr Draghi is caught between a rock and a hard place with populists on the rise in his native Italy. There is a powerful movement demanding fiscal stimulus the country can only afford if the ECB suppresses yields on Italian debt by bond buying – the process of QE that Mr Draghi has signalled is to end. Back-tracking would anger both established conservative parties and rising populists within the EU’s financial powerhouse, Germany. If the Italians do push on regardless, there is the very real worry Italy may default, which would hurt several institutions and trigger a new European banking crisis. To make matters worse for the Europeans, political unrest is now spreading in France, where there have been riots against fuel duties. Growth projections have been moderated, but not drastically scaled back.

Instinctively, it feels as though asset allocation for 2019 ought to be defensive once again. The first thing to question, however, is the size of the cash holdings. Cash does protect against the worst drawdowns in equity markets, but inflation is creeping up and there is a potential impact on prices of a hard Brexit, so a large position will act as a drag on real returns – inflation is effectively the price of the insurance premium against falling share prices. Nevertheless, we will reduce the cash holding to 10 per cent in each portfolio.

The reason for this reduction is that US Treasuries are now offering an attractive low-risk defensive position. The US yield curve is flattening, which indicates lenders no longer expect rates to keep on rising. This implies a reduced risk of price falls because yields are being forced up. Given that US Treasuries offer a spread over UK government bonds and there is the added benefit of returns being in dollars, adding a short-duration (bonds with less time to mature and therefore less sensitivity to interest rates) US Treasury ETF makes a nice addition to the portfolios. These will take up 7.5 per cent of each portfolio.

This means we have a further 5 per cent to find from elsewhere (in addition to the 2.5 per cent invested from cash positions). For the general TAA portfolio, we’ll reduce European equities and UK mid-caps to 5 per cent of the portfolio each. For the MF portfolio, we’ll lower the UK dividend ETF allocation to 5 per cent and lower overall equity exposure further by cutting our quality ETF position. In the general TAA portfolio, the impact on the overall equity-to-bond split is lessened by taking 2.5 per cent from the MI Twenty Four Monument Bond Fund and beefing up the Japan holding to 7.5 per cent. In Japan, they have some good companies with scope to improve payout ratios and, after an uninspiring 2018, Japanese equities could have scope to re-rate higher.

These changes leave the portfolio still relatively underweight the US stock market compared to global market cap, which given the possibility of further reratings of large S&P 500 constituents is probably prudent. All in all, the portfolios are still quite unadventurous, but the hope is that rather like an uninspiring Christmas gift that gets recycled between family members each year, at least they will prove durable.

 

General tactical asset allocation portfolio
Fund (Those in bold to be replaced for 2019)2018 allocation (%)Total returns %(16.11.2017 to 03.12.2018) New 2019 allocation (%)
iShares FTSE 100 (ISF) 7.50.477.5
Vanguard FTSE 250 (VMID)7.5-2.765
db x-trackers Eurostoxx (XESC) 7.5-8.755
Vanguard S&P 500 (VUSA) 7.514.257.5
Vanguard FTSE Japan (VJPN)50.617.5
iShares Emerging Markets (EMIM) 7.5-4.137.5
SPDR Barclays 1-5 yr gilts (GLTS) 50.345
Lyxor iBoxx $ Treasuries 1-3 year (U13G)  7.5
iShares £ Corporate Bond 0-5 yrs (IS15)50.135
HSBC FTSE EPRA Nareit (HPRO) 104.8310
Invesco Physical Gold (SGLD) 5-4.825
M&G Listed Infrastructure 104.4410
MI Twenty Four Monument Bond 100.827.5
Cash (assumed compounding of 1 mth GBP LIBOR) 12.50.610
 Overall total return0.86 

 

Multi-factor asset allocation portfolio
2018 Fund  (Those in bold to be replaced for 2019)2018 allocation (%)Total returns %(16.11.2017 to 03.12.2018) New 2019 allocation (%)
iShares World Quality (IWQU)105.257.5
iShares World Min Vol (MVOL) 107.110
iShares World Value (IWVL) 10-1.1410
SPDR UK Dividend Aristocrats (UKDV) 7.5-6.495
db x-trackers Eurostoxx (XESC) 5-8.755
Vanguard FTSE Japan (VJPN) 50.615
iShares Emerging Markets Min Vol (EMV) 51.85
Lyxor iBoxx $ Treasuries 1-3 year (U13G)  7.5
iShares £ Corporate Bond 0-5 yrs (IS15) 50.135
HSBC FTSE EPRA Nareit (HPRO) 54.835
Invesco Physical Gold (SGLD) 5-4.825
M&G Listed Infrastructure 104.4410
MI Twenty Four Monument Bond 100.8210
Cash (assumed compounding of 1 mth GBP LIBOR) 12.50.610
 Overall total return 0.96 

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