Benefits of active asset allocation in heated markets

The eruption of the volcano Klyuchevskoy

For adviser use only

 

With many markets looking richly valued, now is the time when active asset allocation can be of real benefit, says Aegon Investment Director Nick Dixon

The last couple of years have been a rewarding time for passive investors.  In general, most markets have had a good run and those who are in diversified multi-asset portfolios with static or market-cap weighted assets have benefited.

Returns have been aided by improving macroeconomic stability in developed markets, with the US leading the charge.  Prolonged quantitative easing has also driven high bond valuations, with yields at historic lows.

However, there are now signals that the market environment is changing and that richly priced asset classes may start to return to fair value. Those whose asset allocations don’t have the flexibility to adapt may be vulnerable to market shocks.  Now may be a time when active asset allocations demonstrate the value they can offer.

Three reasons you don’t want to be tied to market cap

Negative US equity market expectations  

Static asset allocation strategies typically track the capitalised weighting of global markets. Passive exposure to the market-cap weighted MSCI All Countries World Index produces around 53% exposure to US equities*.  However, a number of fund managers now believe US equities look expensive.  In the global fund manager survey by Bank of America Merrill Lynch, a net 84% of fund managers recently said they believed the US stock market was overvalued – the highest proportion since 1998.  

With price to earnings ratios in the US at levels not seen since the dotcom crash, and the US dollar relatively high vs sterling (see below), we see an elevated risk of sterling rising relative to the dollar.

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Source: Morningstar Investment Management, as at 30 June 2017. For illustration and analysis purposes only. Past performance is no guide to future performance. 

Interest rates set to rise

Bond prices have surged since 2008 on the back of record low interest rates and quantitative easing. Yields are now at record lows and many bonds effectively now offer negative real returns. The Fed has raised its central interest rate three times since December 2016 to 1.25% and both the Bank of England and European Central Bank (ECB) have hinted at upcoming rate rises or, at the very least, an easing of quantitative easing.  No one is expecting interest rates to begin an unstoppable climb, however current yield curves are too sanguine in light of rising inflation across developed markets and richly valued asset prices.  Hence the downside risk of bonds exceeds potential upsides. Those whose funds have a set allocation to bonds will have no ability to reduce their weighting despite this market context.

No cash defence

With bonds and equities both looking richly valued, cash has become relatively more attractive as a safe haven. Few of the passive vehicles which have been doing so well over the past couple of years have any material allocation to cash.  This may become a problem as other asset classes revert to fair value.  The role of cash in asset allocation should not be overlooked –a low yield of 0.25% may look more attractive should negative returns prevail elsewhere.

Static versus strategic asset allocation

These warning signs offer a strong argument for diversification and having the flexibility to alter asset allocations to mitigate market corrections.

While in the recently benign market environment static asset allocations offering fixed weightings across global equities and bonds have done well, such funds have nowhere to hide and no means to act should markets start to turn negative

At potential inflection points such as these, you may want to examine your clients’ multi-asset holdings to see how much flexibility they have to adapt, and how much exposure to markets like the US they have.  When valuations feel high, it may be the time for both prudence and for active asset allocators to prove their worth.

Aegon’s Core Portfolios combine passive components with long-term strategic asset allocation, advised by Morningstar. In light of rich valuations, Aegon has de-risked asset allocations in its Core Portfolios. 

*MSCI ACWI Index June 2017

 

The value of an investment can fall as well as rise for a number of reasons, for example market and currency movements. Your client could get back less than originally invested.

This article is based on our understanding of the current and historical position of the market(s) and shouldn’t be interpreted as recommendations or advice. Past performance is not a reliable indicator of future results.

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