There’s a lot to consider when running your own diversified portfolio and a key decision is what approach to take. Do you keep abreast of the world’s economic situation, or are you more laid back? Will you actively tinker with allocations to different asset classes to match the economic circumstances, or will you leave things static and let diversification run its course over the long term?
Many an academic paper has been written on this subject. A common myth is that, on average, 90 per cent of a portfolio’s return is derived from long-term asset allocation and only 10 per cent from short-term active changes or stockpicking. This statistic is derived from two studies by Gary Brinson, Randolph Hood and Gilbert Beebower in 1986 and 1991. And it is often misquoted, according to David Larrabee of the CFA Institute, an education and industry body for professional investors.
He says the authors suggested that a portfolio’s long-term asset allocation explained 90 per cent of the difference in performance between different portfolios – but not necessarily that it provided 90 per cent of the return.
Mr Larrabee adds that a later study found that 75 per cent of the difference between a portfolio’s return and an average portfolio came from the difference in long-term or static asset allocation – with active changes accounting for 25 per cent of the difference. So the original 1986 and 1991 studies may have understated the impact of making short-term asset allocation changes.
Opinions will always be split. Some investors will always wish to actively change asset allocation so the portfolio is tilted towards the right assets at the right time. Others will disagree and suggest you can never time things well enough, so why bother.
Control what you can
As with most things, the answer is something more nuanced. And whichever camp you fall into there are important things to consider.
Gary Potter, co-head of multi-manager at BMO Global Asset Management, falls firmly into the second category. He says he has never met any manager that can consistently make market calls and rarely attempts to do so in the fund-of-funds he manages. He suggests the most important factor is the quality of the underlying investments.
Asset allocation is just like stockpicking, in that it can be top down (starting from a macro-economic perspective and picking investments) or bottom up (picking an investment based on its own merits and fundamental prospects). Both can create a portfolio within an asset allocation framework.
“Both ways can work, but we are heavily biased towards [investment] selection powering [outperformance] over macro asset allocation,” says Mr Potter. “There is a misunderstanding over how important asset allocation is, can be or should be and there is a misguided view that [active] asset allocation is the only game in town.
“We reckon at least 75 per cent of our performance is derived from the bottom-up [security] selection and I have never met a manager who says they get all their performance from active asset allocation.”
He says such a tactic comes from an understanding of their own shortcomings on making macro-economic calls, so he would never say Japan has reached full value and sell down everything and shift it into another region. The team instead picks funds and keeps portfolios invested around a long-term diversified asset allocation model – depending on different risk tolerances.
“We want to spend more of our time on what we have control over, which is the quality of [investments] we put in our portfolios,” he adds.
Yet, Mr Potter remains pragmatic. “We are still on top of asset allocation – we have a best estimate [of performance] based on bullish, bearish and core scenarios and we would not underappreciate the benefit of designing them using a macro perspective.”
He says the team may make calls “at the margins” – shifting 1 per cent between regions or taking profits.
Riding the cycle
However, others start from entirely the other end of the spectrum. Peter Elston, chief investment officer at Seneca Investment Management, is one user of a macro-economic or business cycle model to decide asset allocation.
Mr Elston’s multi-asset fund-of-funds’ asset allocation changes continuously depending on where the team feel the global economy sits in the traditional business cycle model. This model suggests that economies go from ‘recovery’ to ‘expansion’ to ‘peak’ and Mr Elston believes there is an ideal allocation to equities within each period and inter-period.
History suggests that equities do best immediately after the end of the 'peak' phase and so, as ‘recovery’ begins, the portfolio should have its highest weighting to this asset class. As ‘recovery’ turns into ‘expansion’ equity allocations should gradually reduce, taking it down to its lowest level as the cycle enters ‘peak’ – before quickly ramping up again.
Mr Elston says he decides where the economy is in terms of the cycle using macro economic data, which can help determine where interest rates will go – a key influence on the business cycle.
However, this strategy is not perfect. Macro-economic data may suggest the global business cycle is in expansion stage – but it cannot tell you how long each stage will last, meaning a gradual reduction in equities may leave you at a low level of equities longer than necessary.
Mr Elston’s model suggests the current cycle will reach its ‘peak’ by 2020. As such, he has been systematically reducing equity holdings mainly in the US – the leading economy in the cycle – since December 2016. Since then, the S&P 500 index has risen 25 per cent in dollar terms and has shown few signs of slowing down.
Mr Elston says the Seneca multi-asset funds’ performance has remained competitive, but that is due to shifting equity allocations into alternative assets – such as property and more esoteric debt investments – instead of basic bonds.
But he admits using a business model cycle is not that simple, and requires nuance. “There’s always the case that the recovery or expansion stage could be longer than average – and we’re seeing that here due to the size of the recession before it. Our base case [for peak] is 2020, but good asset allocation is not necessarily dependent on timing, it’s knowing where you are,” he adds.
“I didn’t go underweight equities until I was sure we were in the expansion phase. [Reducing equities] is braking before you get to the bend,” he adds.
Others take this one step further. The multi-asset team at Royal London Asset Management use a model called the ‘investment clock’. This also follows economic and business cycle analysis, but goes into more detail over which asset class is most suitable when.
It breaks down the economic cycle into ‘recovery’, ‘overheat’, stagflation’ and ‘reflation’ and suggests that over this cycle inflation will rise, growth will then fall below trend, inflation will then fall, and then growth will then move above trend. It breaks down individual equity sectors, and other assets such as commodities, inflation-linked bonds, government bonds and corporate bonds, and highlights which assets work when.
However, this method faces similar issues to Mr Elston’s. Mr Potter adds: “Because of quantitative easing, the inflation cycle and growth cycle have been stretched. We have learned that while you can be a hero, things can take a long time to manifest.”
Backwards and forwards
Neither approach is perfect – one requires the investor to choose the right asset mix and then to take a back seat, while the other requires a good understanding of macro-economic pointers and where the business cycle is, and then deciding what the best asset class for the time might be.
Brad Holland, senior investment manager at wealth manager Nutmeg, says one consideration is whether you prefer your portfolio to be forward-looking or based on a backward view.
“There are two things to decide – what should be your static or long-term asset allocation and how do you set that up. And then there's the question of do you actively manage around that or just re-balance.
“A static long-term is going to be mainly backward-looking as the way it is set up, in terms of asset selection, will be conditioned by what has happened in the past and how they have performed. An actively managed portfolio is the reverse, it will have some backward-looking elements such as how stock markets relate to other assets or macro data, but primarily you would be looking forward at the cycle,” he says.
Mr Holland says the fixed and active approaches are “very different animals”, but deciding which way to go depends on three things: how cost conscious an investor is, the investor's time horizon, their ability and their risk tolerance.
“Managed portfolios require a lot of intellectual oversight, and that will be more expensive to run,” he says. The cost element isn’t simply the trading costs of regularly changing a portfolio, but also an investors’ time. Is the time spent worth the potential additional returns? Also, investors must be wary of the cost of being wrong.
“If you’ve decided that you’re going to be the master of your own ship, then you have to be comfortable with [being wrong],” Mr Holland adds.
Time horizon is important. If investors are investing for the long term and over multiple business cycles, then market timing is less important because everything should average out. If investing over a shorter timeframe, then it is good to know where you are in the cycle so you do not not allocate 100 per cent to equities at the peak.
Mr Holland adds: “Know your time horizon, know your risk appetite so if you do run into a storm you know you’re going to react, and understand it yourself. If you’re going to stress yourself then this might lead to bad decisions such as pulling out of the market at the wrong time.”
