28 November 2017
The past eight years were friendly to investors. Stock and bond prices soared, and volatility collapsed. For much of the period, the dispersion of returns within asset classes was below historic norms. In short, it was difficult to beat the index.
As we exit this long and fruitful period, investors must guard against complacency, including misplaced faith that a "balanced portfolio" of equity and bond exposures remains prudent. As the drivers of return change, so must investing behaviour.
So just how good have the past eight years been? From their low point in March 2009, the S&P 500 and the MSCI World Equity Index returned over 275% and nearly 192%, respectively, over the ensuing 8.5 years. The Bloomberg Barclays Global Aggregate Bond Index appreciated by almost 40% over the same period. Still, that’s a not-too-shabby 4.2% per year return for a collection of mostly safe bonds. For the fortunate investor who parked money in the quintessential 60/40 portfolio of global equities and a bond index fund over the entire period, the average annual return came to over 15% (gross). Moreover, the corresponding Sharpe ratio was comfortably above one.
A genuine free lunch
Little wonder, therefore, that index-tracking, low-cost instruments have mushroomed in popularity since the global financial crisis. The vast majority of returns were driven by market directionality (beta), which could be achieved in tandem with low volatility and low cost.
Yet there is something fundamentally troubling about such portfolio returns. That is because they don’t sit comfortably with the fundamental underpinning of asset allocation. At its core, multi-asset investing involves exploiting a genuine free lunch in markets: the ability to increase return for a given level of risk (or to reduce risk for a given level of return). Index-tracking portfolios will not always deliver that basic aim of multi-asset investing.
To see why, consider an alternative scenario -- a sudden burst of inflation. The consequence would be ruinous to the simple 60/40 index-tracking portfolio. Bond prices would sag as investors anticipate a sharp tightening of monetary policy. Equity risk premiums would almost certainly jump, given increased cyclical uncertainty as monetary policy makes an abrupt U-turn. Stock and bond prices would plunge simultaneously.
To be sure, a surge in inflation is nowhere in sight, and remains improbable. But equally improbable is a continuation of the stellar stock and bond returns achieved over the past eight years or more. The restoration of fuller employment in North America, the UK, much of Europe and Japan requires the removal of highly accommodative monetary policies. A gradual increase in inflation is more probable than not. Going forward, bond investors will be fortunate to muster half the returns achieved on average since 2009. And if bonds repeat their strong performance since 2009, equities will tank. From here, bonds can only rally on weaker growth and falling inflation, a nightmare for equities at prevailing valuations. Volatility, too, is more likely to rise than to fall.
Simply put, the days are numbered for the multi-asset trinity of positive correlation, high return and low volatility.
What comes next?
Much depends on the ability of the world economy to continue to deliver synchronous, moderate and non-inflationary growth. But some contours of the new state of play are already apparent.
- Future returns will be lower because markets are overvalued, bonds more so than stocks.
- Positive stock / bond price correlation is a thing of the past, to be replaced by fluctuating correlation (barring the aforementioned inflation surprise).
- Dispersion within markets will become more important. Partly, that reflects the rapid transformation of business models by new technology and the acumen with which individual company management is able to respond. But dispersion is also gaining in importance as the contribution from broad market moves fades.
- As for volatility, it is already near historic lows. And the shift from central bank certainty to "discretionary normalisation" will almost certainly increase monetary policy uncertainty. Doubts about inflation or geopolitical tensions are also likely to contribute to bouts of unsettled markets.
All of this brings us to an irony. Simple asset allocation has delivered strong performance since the financial crisis. Yet that strategy is no longer viable. What must replace it? The answer is: simple asset allocation.
Except that this time, investors will require portfolio construction based on diversification, not mere return-chasing.
The starting point is a judicious allocation to equity markets where earnings are supportive. Candidates include emerging markets and Europe, which are enjoying a cyclical recovery of profitability, as well as industries benefiting from new technologies. Financials may also be worth a look.
In fixed income, the universe of candidates is smaller. Certain forms of subordinated debt remain attractive. Less liquid structures, including private credit and off-the-run asset-backed securities, offer diversification and returns commensurate with risk.
Lastly, liquid alternatives may create stable sources of return that complement more conventional holdings in multi-asset portfolios.
But most important may be portfolio construction. They key to long-run effective asset allocation is an ability to identify weakly correlated returns and combine them appropriately to create a diversified portfolio. In a world of variable correlation, lower index returns, greater dispersion and episodic volatility, the first step for investors is to go back to basics of uncorrelated portfolio construction.
Originally published in Bloomberg View 2017. Reprinted with permission. The opinions expressed are those of the author.
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The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.