The return generated by a diversified fund or mix of assets essentially will be a function of three things:
• The fund’s medium- to long-term allocation to each asset class (for example, 30 per cent in Australian shares, 25 per cent in bonds, 10 per cent in property, etc) and hence the market return they generate. Technically this is referred to as the fund’s strategic asset allocation or SAA.
• Any short-term deviation in the asset mix away from the SAA. This is referred to as the tactical asset allocation or TAA.
• The contribution from active management of the underlying asset classes, often referred to as security selection. In the past, this was largely undertaken by just one manager but it has become common to use a multi-manager approach in each asset class.
In an environment of good returns from all asset classes, and where returns in the two main asset classes of shares and bonds move together, the benefits of asset allocation are masked as buy-and-hold strategies work well. This is what applied through much of the 1980s and 1990s, when asset allocation faded in perceived importance relative to manager selection.
This begs the question: if we are heading into a new secular bull market in shares, will there be a renewed decline in the perceived importance of asset allocation in favour of a return to simple buy-and-hold strategies?
I believe that, while there will no doubt be periods of high returns, as in the past year, asset allocation is likely to remain critical, for a number of reasons.
First, the broad return backdrop is likely to be constrained, with not all asset classes doing well. The starting point for returns today is much less favourable than when long-term bull markets last started in bonds and equities in 1982. The yields on all asset classes, particularly bonds, are much lower. Equities are unlikely to have the tailwind of rising profits relative to GDP because profit shares are already high. And equities and bonds won’t have the combined tailwind from falling inflation which 30 years ago benefited both as the yield structure fell, providing a huge valuation boost to returns.
In fact our medium-term return projections imply a 7.5 to 8 per cent annual return from a diversified mix of assets. This is well below the average 11.9 per cent annual return that Australian diversified funds provided over the 1982-2007 period. In a world of constrained returns, getting the right asset allocation will be essential as opposed to a high-return world where it’s not as much of a focus.
Second, the potential return range between the major asset classes is likely to be wide, ranging from just 3 per cent a year for Australian government bonds to just over 10 per cent a year for Asian shares. Conceivably, given the way markets go, the range could be even wider than this. This will add to the importance of getting asset allocation right. In particular, holding low yielding bonds and cash could lock investors into low returns.
Third, while volatility is likely to be down on the extremes seen in the past few years, it is still likely to be relatively high. Public debt problems are likely to flare up periodically, the world is becoming more reliant for growth on naturally volatile emerging countries, and extremely easy monetary policy conditions will provide a source of volatility when they will have to be reversed at some point.This is all likely to result in continuing volatility in asset class returns, providing opportunities for asset allocation to add value to investment returns.
Finally, bond and equity returns are likely to remain negatively or lowly correlated, providing an opportunity for asset allocation to enhance returns by moving between the two. This is evident in the chart which shows the rolling three-year correlation between bond and equity returns in Australia and the US since 1950. Through the 1980s and 1990s, return correlations between bonds and equities were mostly positive reflecting the common driver of the adjustment to a low-inflation world. But starting over a decade ago, this had run its course and so the correlation turned negative as investor sentiment swung more aggressively between “risk on” (favouring shares) and “risk off” (favouring bonds).
So while the world is gradually healing, which should result in a better environment for equities, asset allocation is likely to remain critical due to likely constrained returns, a large variation in returns between major asset classes and ongoing volatility.
Shane Oliver is the head of investment strategy and chief economist at AMP Capital.