Asset allocation – does more deliver less?
For adviser use only
Asset allocation tends to be a bigger contributor to fund returns than stock selection. But is there a tipping point where too many asset allocation changes add cost to a portfolio rather than aiding returns? Conversely, do too few changes restrict the ability to take advantage of market gains while avoiding the worst of market falls?
Questions of value such as these are front of mind in the wake of the FCA’s Asset Management Market Study, and they are important to financial advisers who operate in an increasingly cost-conscious market. Here we assess the value credentials of the three main approaches to asset allocation being used in risk-managed portfolios.
Tactical, strategic or static?
In general, asset allocation strategies fall into the following categories:
- Tactical asset allocation (TAA) - those adjusting daily, weekly or quarterly in response to both medium and long-term market changes, typically with a fund charge of 0.45%-0.70%,
- Strategic asset allocation (SAA) - those adjusting mainly annually or bi-annually based on long-term expectations for asset classes. These funds generally cost 0.20%-0.30%
- Static asset allocation – those simply rebalancing to maintain a split between equities and traditionally lower-risk asset classes like bonds. These funds don’t make market calls and are the cheapest at around 0.10%-0.25%
Given their additional cost, you would expect tactical funds to deliver higher returns as they adjust to take advantage of, or defend against, short-term market fluctuations, but is this actually the case?
Growth markets – trouble for tactical
Below we show how these three types of asset allocation strategy have fared over the last four years – a period in which most markets have achieved strong growth. All funds in the chart use passive components, but they manage asset allocation in different ways.
The dotted blue line takes the ‘line of best fit’ for a basket of fund ranges which use tactical asset allocation, and crosses mark the returns of individual funds in this category. The orange ‘SAA funds’ line shows Aegon’s Core Portfolios, which use a strategic asset allocation approach. And the grey line models index returns after charges for five portfolios with static equity/bond splits, rebalanced daily.
Looking at returns over the past four years, the clear winners on a risk-return basis were static funds, followed by the strategic approach. In contrast, no premium was received for investing in more expensive tactical funds.
For these tactical funds, asset allocation opportunities are borne out of human error; over- or under-reaction to recent economic or political events like oil price changes, elections or the Brexit referendum. The ability to defend against market shocks should be the greatest advantage of tactical asset allocation. These funds are also more likely to include absolute return strategies to allow some capacity to make gains in falling markets, though this element increases overall portfolio costs.
However, with larger companies in core markets like the UK and USA propping up returns despite an uncertain political climate, it has been hard for tactical funds to beat those that make less frequent changes in recent times. Markets haven’t necessarily reacted as managers expected to political news or economic announcements. Few would have predicted that markets would recover two days after the Brexit vote and a day after Trump became US president for example.
The static portfolios shown were also aided by their avoidance of both property and cash – which strategic and tactical approaches tend to use for diversification purposes and as a way of managing risk. In an environment where equities generally fared well, and bonds offered QE-boosted returns far in excess of historic norms, static portfolios were clearly dominant.
But in a market context where both asset types now look highly valued, and where we have increased weightings to cash in our own strategic allocation funds – our Core Portfolios – the sustainability of static asset allocation approach may be called into question.
Falling markets – static sinks
At the other end of the spectrum, a static fund doesn’t have the flexibility to change its asset mix defensively to reduce the impact of market drawdowns. Looking at the same static allocations over the credit crunch, you can see below that when equities nosedived the portfolios followed them down, suffering losses in proportion to their equity content.
The issue for static funds is that they have nowhere to hide when markets fall. Those with a freer mandate could move out of equities into more defensive assets like bonds and cash which were relatively resilient over the same period, as you can see in the chart below. This isn’t to say that fund managers will always predict outcomes accurately – but the flexibility to act can be extremely valuable.
The strategic value of sticking to fundamentals
Sitting between the tactical and static approaches are strategic asset allocations which focus on long-term fundamentals. Morningstar, who manages the strategic approach deployed in Aegon’s Core Portfolios, defines risk as ‘the permanent loss of savings’. This differs from a tactical approach which views short-term changes in price as risk.
To illustrate the difference, Morningstar points to our credit crunch example. During this period long-term corporate fundamentals for US stocks fell 7.2%, but the price-implied growth expectations – which might be a focus of tactical allocations – dropped all the way to zero. The market effectively said that US businesses would never grow again, which was patently not credible.
This isn’t to say that our Core Portfolios would never respond to a near-term market change. The point is that they would do so both carefully and sparingly. While sensible changes can be helpful, too much can simply add cost and raise the risk of behavioural bias.
Not too much, not too little
While a tactical approach to asset allocation gives the most flexibility to respond to market changes, it can risk losing focus on the long-term fundamental values which markets typically revert to. Only where tactical strategies can demonstrate the additional returns their process adds, are clients likely to feel that the extra cost offers them value for money.
In contrast, a static approach can be both cheap and effective in generally buoyant markets – as we have seen in recent years. But the lack of flexibility these strategies offer when markets turn negative could undermine their strong run over a full market cycle. With current valuations looking rich in a number of key markets we are already seeing more flexible strategies take defensive positions while their static counterparts are unable to act.
We argue for something in the middle. Looking at long-term valuations across different asset classes and comparing them to current prices is more likely to deliver reliable growth that isn’t swayed by near term noise, but has enough flexibility to respond to changing conditions.
Past performance is no guide to future performance and the value of investments may go down as well as up.