By Richard Gardiner, Head of the Investment Strategy Group, Chief Investment Officer, Neuberger Berman Trust Company N.A.
Since the financial crisis, some investors have taken wrong turns in the name of diversification, but we believe the long-term benefits of asset allocation remain clear.
For many investors, the 2008 financial crisis reinforced the value of effective asset allocation. However, the trauma of the experience appears to have distorted the concept of asset allocation in some mainstream commentary that has become overly fixated on short-term objectives.
Asset allocation refers to the manner in which an investor apportions his or her investments among various asset classes. At a basic level, asset allocation considers traditional investments such as cash, stocks and bonds. Subcategory classes may be targeted to geographic regions, industry sectors and market capitalization size. Alternative classes typically include private equity, real assets and hedge funds.
Research has shown that, often, a significant portion of a portfolio's investment returns are attributable to asset allocation, rather than the selection of underlying managers or individual securities.1 Moreover, effective asset allocation can often produce a portfolio with less risk than the component holdings. Asset allocation employing mean variance optimization incorporates three variables: the estimated returns of various asset classes, the volatility of those returns and their correlations to each other. These elements are combined to construct a portfolio designed to maximize the estimated return for a targeted level of risk, or the lowest risk for an estimated return target.
What has gone wrong for investors since the financial crisis and why has asset allocation come under fire? For many investors, it has been largely a matter of timing and a counterproductive short-term focus.
1. Staying in Cash Too Long. Many investors sold equities to cut risk during the bear market of 2008 and early 2009. Portfolios on average held more than 40% cash in the first quarter of 2009 (see display below)2 and, as a result, many investors have not fully participated in the robust recovery. Since January 2009, the S&P 500 has provided a total return of +183% or +14.5% on an annualized basis.3 In effect, many investors who had moved into cash did so at the wrong time and stayed there too long. Of course, with perfect hindsight, it is far too easy to criticize investors who sold equity holdings during the relentless decline, yet one of the advantages of asset allocation planning is that it can provide a framework with which to systematically and rationally rebalance one's portfolio during a drawdown when emotions might otherwise take over.
Cash Moves Were Poorly Timed
S&P 500 and Cash Allocations
Source: FactSet, American Association of Individual Investors (AAII), as of September 26, 2016. The AAII's Asset Allocation Survey measures the average percent of cash held in respondents' portfolios. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
2. Reactive Hedging. In an attempt to dampen volatility and to seek uncorrelated returns after the crisis, many investors also added hedge funds to their portfolios. Recent hedge fund performance has led to widespread criticism of hedge funds and many investors are questioning whether the asset class is still worth investing in.
It is true that many hedge funds have delivered disappointing returns in recent years (some while imposing high fees and illiquid terms on investors). From January 2009 to September 2016, the HFRI Fund Composite Index has generated a +5.8% annualized return compared to a +14.5% annualized total return for the S&P 500.3 However, there is an egregious misperception that hedge funds should always beat the market. Hedge funds encompass many strategies, but are commonly used to lower beta or net exposure to markets. It is understandable that hedge funds have underperformed long-only strategies during a period in which equity indices have more than doubled in value.
The fact that many hedge funds have underperformed recently does not mean this will continue, and more importantly, it does not mean that asset allocation does not work. It is worth noting that the HFRI Fund Composite gained +5% on an annualized basis from January 2000 to December 2008, versus a -3.3% annualized loss for the S&P 500 total return over the same period. Hedge funds have also fared better than global stocks during each of the S&P 500's worst 10 months since January 2000 (see display).
Recent Hedge Fund Disappointment Overlooks Equity Market Declines
Hedge Fund Performance During the 10 Worst Months for Equities, January 2000-September 2016
Source: PerTrac. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
3. Waiting for Emerging Exposure. Emerging markets were among the first asset classes to recover immediately after the financial crisis, as these regions were less vulnerable to the protracted slowdown in consumer spending that had spread in developed markets. The MSCI Emerging Markets (NYSE:EM) Index rose over +100% in value from January 2009 to June 2011 compared to a +46% gain for the S&P 500 Index. The disparate gains speak to a goal of asset allocation: to capitalize on diversified return streams. Unfortunately, investors largely waited to add EM exposure until after EM equities started to rally. The momentum psychology phenomenon can also be seen more recently in investment flows in and out of Chinese equities over the past two years. As shown below, investors began to consistently reduce exposure to the region only after the market suffered a steep decline in early 2015. Effective rebalancing is designed to do the opposite.
Emerging Markets Flows Follow Recent Performance
MSCI China Index Returns and China Region Flows
Source: Morningstar. U.S. ETF flows focused on China region. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
Planning for the Journey
None of the above asset allocation trends were effective, and all arguably hurt. Using the metaphor of driving a car, the concept of asset allocation was contorted into driving via the rearview mirror - i.e., reacting to earlier events. Investors need to look forward instead, through the windshield, and they need a long-term plan.
Asset allocation is not always easy, even when an investor has a long-term plan. One reason is that investors get bombarded by noise from the 24-hour news cycle and the allure of in vogue market segments with attractive short-term returns. Sticking with the metaphor of driving, asset allocation is comparable to a cross-country journey and pitches for those markets are comparable to the enterprising highway restaurant blasting a sign, "Fresh Doughnuts - Last for 200 Miles!" As you approach, you notice that the parking lot is loaded with cars (read asset flows from other investors and recent strong performance). So, you pull over and enjoy the doughnuts. Yet farther on, you come across other restaurants. While the sign was "accurate" - it was indeed the "last" doughnut shop - there were many other, healthier food options available down the road.
The lesson is that investors may need to forgo tantalizing short-term opportunities in order to stick to a sensible long-term plan. Asset allocation provides a steering wheel and investors can and should maintain some flexibility to changing conditions - but too many changes risk creating a whipsaw effect. Said differently, you can't yank the steering wheel at every alluring exit, or you will never make meaningful long-term progress.
Allocating in Today's Environment
Establishing an effective asset allocation is essentially a three-part process. As a starting point, you and your advisor should look at all your investments to establish your aggregate portfolio. This administrative/organizational task is often overlooked and yet it is vital. Far too many investors have investments in various unconsolidated accounts with no awareness of the entire picture. Next, you determine your investment goals, time horizon, liquidity needs and risk tolerance. The latter may relate to the volatility of returns, drawdowns or even dissatisfaction with being up less than their benchmark in bull markets. Once those parameters are established, the next step is to draw the broad lines of your portfolio, establishing long-term asset allocations as well as guidelines for potential short-term tactical tilts. With a developed asset allocation plan, you and your advisor have a framework for implementation, as well as for periodic review and reassessment of your portfolio.
In general, equities have offered higher upside potential over the long term for those willing to accept greater volatility. Right now, however, equities are not cheap, and earnings momentum remains weak, although there are select opportunities. Traditional fixed income has generally offered stable yields with reduced portfolio volatility. Because yields are so low, we currently favor bonds with shorter durations. Alternatives such as option overlays and private equity strategies can provide valuable diversification and additional sources of total return potential.
Effective asset allocation is not about making bets. It is designed for the long haul, and a focus on short-term results may be counterproductive. From our point of view, asset allocation is about analyzing a potential range of outcomes, and then using that information along with the client's investment profile in seeking to build portfolios with favorable risk-adjusted return profiles. Over the last few years, asset allocation has taken some hard knocks, but we believe it is far from obsolete. On the contrary, the framework it provides can be an invaluable "map" as investors plan for their long-term financial goals.
1Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, "Determinants of Portfolio Performance," Financial Analysts Journal, Vol. 42, No. 4 (Jul. - Aug., 1986), pp. 39-44.
2Source: American Association of Individual Investors.
3Source: Bloomberg, as of September 26, 2016.
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