At the recent IMAP Portfolio Management Conference, a representative of Schroders Investment Management gave a refreshingly honest presentation where they conceded that achieving its CPI plus 5 per cent return target of their Real Return Fund could be challenging over the next 3 years. Further, the funds manager suggested that most asset allocation mixes selected from the range of mainstream asset classes would also fail to meet objectives – even with considerable additional risks being taken.
The Schroders representative did provide the caveat that this outlook assumed a static asset allocation over the next three years. However, alpha from investment selection and/or dynamic asset allocation (DAA) would be essential in meeting the return objective, and this fund does have the flexibility and approach to pursue these. Schroders also emphasised the importance of the fund’s risk objectives in terms of limiting volatility and drawdown in the current environment. The funds manager’s key message was the importance of having enough flexibility in approach to be defensive when you need to – such as today – in order to have enough ”dry powder” to exploit opportunities at better valuations when they present themselves in the future.
However, increasingly conventional, Strategic Asset Allocation (SAA) driven investment portfolios don’t have such scope. Under pressure to lower cost and keep up with strong markets they have increasingly embraced passive or near passive strategies for large parts of the portfolio. Chasing growth and momentum and impatient with underperforming managers – mostly value – and strategies, anything lagging and most things contrarian or alternative are being quickly dropped from portfolios in favour of more beta, more growth, and ultimately more risk.
Sticking close to SAA is seen as the safe strategy, given the difficulty of adding value in DAA in recent years, irrespective of the current valuations of asset classes. The growth of ETFs has allowed quick and low-cost access to many of the building blocks for such portfolios.
Where portfolios have diverged from a conventional asset allocation it has typically been into increasingly crowded strategies like chasing yield or the recent trend to add illiquid and arguably also expensive private equity, infrastructure and property in a quest to “diversify” and look more like industry funds.
This is the first article in a two-part series I’ll write for Professional Planner questioning whether conventional approaches to managing portfolios are equipped to deal with the investment environment and the set of circumstances we find ourselves. The second article in the series deals with how advisers and investors should respond.
In practice, many portfolios end up owning mostly expensive asset classes and the more expensive components of these. Such portfolios look good on backward measures such as historic return, chance of negative return, maximum draw-down and the like, but in today’s abnormal financial environment such backward looking numbers are far less reliable than usual.
While “this time is different” are dangerous words in the investment world, it is increasingly obvious that in some respects “this time really is different”.
What we’re dealing with
Interest rates have never been lower in history and are close to zero or negative in large parts of the world – $US17 trillion worth of negative yielding bonds and counting. In response, valuations of share markets are towards the upper ranges of history, despite an environment where debt levels are at record levels and, partly because of this, economic growth is struggling. Yes, abnormally low interest rate levels are seen justifying high equity valuations but if rates are so low because of slow growth into the future, there is no automatic economic reason why this should elevate valuations. Behaviourally, it’s a different matter, as investors desperately chase yield and short-term returns.
What this suggests is there is no certainty that a conventionally diversified portfolio of assets will achieve reasonable, or even positive returns from current levels, even over the medium-long term. We are in an unprecedented financial environment, where historical returns and risks are next to useless as predictors and the returns of many asset classes have been front-loaded to recent years.
Of course, the future is uncertain, and while valuations are a guide to future long-term returns, they are not much help in the short term. And yes, this has all been said before and perhaps this environment can keep going for yet another few years. However, for clients with investment horizons of 5, 10, or 20 years, the likelihood is many portfolios are fundamentally structured to fail current objectives.
Old tools, new rules
Yet large parts of the industry persist in projecting pre-fee, pre-tax nominal returns from conventional SAA driven diversified asset portfolios at 6-8 per cent per annum or even higher. Some seem to get away without having to provide much on expected returns and risks at all.
At the IMAP Conference, one financial planner running investment portfolios also highlighted the challenges of investing in a world of overvalued equity and bond markets and seem resigned that it would end badly. His main take was it would be interesting to see how it all plays out and we will all likely look back and learn lots of lessons. Meanwhile, they seem inclined to stick to conventionally, near fully invested, portfolios. Is that really the best we can do?
Basically, today’s conventional, SAA driven portfolios are like an old, fault ridden car with engine problems and bald tires, but which still looks pretty good on the outside. You keep driving it even though common sense tells you the odds it will break down and fail to deliver you to your destination have increased markedly, but worse, the chance of a crash has also escalated.