- Investment Insight
- 5 minute read
Wouldn’t investing be more straightforward if we had the luxury of unlimited risk and a perpetual time horizon? One could simply hold risky assets and ignore any short-term volatility.
While there is plenty of data to suggest holding shares over a 20+ year time frame will deliver the best overall returns, many investors don’t have this kind of time horizon. Most investors are uncomfortable with the prospect of very large capital losses in the short to medium-term; while there can be no guarantee that even 20 years is long enough to generate sufficient returns.
Advisers often find that clients are comfortable with a rolling 3-5 year time horizon and usually want regular investment reviews in that time too. So what is the optimal mix of asset classes for this time frame (and their given level of risk)? How do you decide which asset classes to include within a portfolio, and in what proportions?
The importance of asset allocation
In a recent article, breaking down multi-asset investing, we established that these solutions can be used to maximise risk-adjusted returns over the long-term. Putting this into practice typically involves using two forms of asset allocation:
- Strategic Asset Allocation (SAA): This is the foundation of multi-asset investing. It involves identifying the most effective combination of asset classes which, over the long-term, is expected to achieve the best possible return for a given level of risk. Investment managers will generally construct a number of SAAs for different risk profiles.
- Tactical Asset Allocation (TAA): There can be prolonged periods when asset class returns deviate from long-term trends. Therefore, once an SAA has been established, an investment manager might apply a TAA overlay – taking active overweight/underweight positions based on shorter-term market and macro-economic opportunities they identify.
It’s difficult to overstate the importance of a well-managed asset allocation process. The overall process is usually a proprietary solution, constructed using a firm's intellectual property. Multi-asset solutions can be used to achieve a range of different outcomes and, as such, cannot simply be derived from the market in the same way that single-asset class managers might make use of readily available indices.
If asset allocation is not derived from a high quality investment process, it’s very unlikely that clients will consistently benefit from investment outcomes in line with their objectives, and optimise returns for the level of risk they are willing to take.
Constructing and managing multi-asset solutions
The SAA is the most important driver of risk and return in multi-asset portfolios. This is backed up by numerous academic studies and widely accepted amongst financial experts.
At Close Brothers Asset Management (CBAM), we too believe that selecting the optimal asset allocation is the key to delivering strong returns for clients over the long-term. We have different SAAs for each client risk profile, and devote substantial time and resource to their construction. Our SAAs embed long-term expected returns, volatility (risk) and asset class correlations. Importantly, they are not a static blend of assets; instead they are dynamic and periodically re-optimised. As such, they should continually account for the evolving market backdrop.
Working with Moody’s Analytics, we analyse the projected risk-return trade-off under various investment scenarios using Moody’s Economic Scenario Generator. This tool contains stochastic models which illustrate the potential distribution of asset returns under real world scenarios. Repeating this process periodically ensures that the SAAs remain an optimal asset class blend, accounting for both an ever increasing stock of historical data and prevailing market valuations. Markets trading on elevated valuations would, in all probability, carry greater risk to the downside and a more limited upside for example, and the potential distribution of returns as indicated by the stochastic modelling would likely be tilted accordingly.
Our risk levels
For illustrative purposes only.
There can, however, be prolonged periods when asset class returns deviate from long-term trends. Periods of recession or financial crisis can see equity markets deliver deeply negative returns for example, while they may then emerge from such periods offering higher than average prospective returns. This is why we believe investors need to be active on a TAA basis, and also in terms of security selection.
The TAA takes an active stance relative to the SAA, with investment managers adjusting portfolio weightings to take advantage of shorter-term market and macro-economic opportunities. Sovereign bond markets in the developed world are perhaps a pertinent current example; bond yields across the US, Japan, the Eurozone and the UK are at (or near) record lows due to weak macro-economic data and significant Central Bank intervention in the wake of the Covid-19 pandemic. While investors in the asset class have benefitted from good returns recently, medium- to long-term returns might appear less attractive, prompting an active manager to underweight their exposure.
At CBAM, the TAA decisions are arrived at through a thorough collegial process, in which we look to leverage the experience and expertise of our senior investment professionals. Over time, we believe these tactical adjustments to the long-term strategic framework can enhance returns, as can active security selection.
It’s important to understand, however, that TAA decisions are made within pre-determined risk parameters, meaning that they will not fundamentally alter a strategy’s risk profile. Markets can change rapidly, but your client’s investment objectives do not. It’s important to ensure the strategy continually reflects their long-term goals.
Finding the right solution for your clients
Constructing and managing multi-asset portfolios can be complex. Some managers discount the TAA process altogether and periodically rebalance portfolios back to the SAA weightings (this might be common for model portfolios available via an investment platform for example). Additionally, active stock selection might be eschewed in favour of index-tracking, passive investments like exchange traded funds (ETFs).
Furthermore, the performance of a multi-asset portfolio might be measured against an internal benchmark, a market benchmark, industry standard fund sectors, or a stated investment aim; like inflation + X%. Whatever the mechanics of the solution, it is important that your clients understand the nature of the investment they are paying for, and that they are comfortable it’s appropriate for their requirements.
Multi-asset investing will undoubtedly continue to evolve in future. The inexorable rise of passive investing over the past decade or so has led to a number of purely passive multi-asset solutions, while passive securities will often form a small part of many active managers’ portfolios too. Within the unitised fund space, a further step advisers can explore is the possibility of combining multi-asset funds to provide a blend of active and passive investment styles, or directly invested and fund-of-fund approaches.
This article is only intended for use by UK investment professionals and should not be distributed to or relied upon by retail clients. The value of investments will go up and down and clients may get back less money than they invested. The information contained in this article is believed to be correct but cannot be guaranteed. Opinions constitute our judgment as at the date shown and are subject to change without notice. This article is not intended as an offer or solicitation to buy or sell securities, nor does it constitute a personal recommendation.