How active asset allocation improves consistency of returns

EBEN KARSTEN

MULTI-ASSET and absolute return investing go hand in hand, as the enhanced diversification provided by multiple asset classes should limit downside risk. Importantly, the objective of these funds is to deliver positive (real) returns, irrespective of market conditions.

In South Africa, the portfolio composition of multi-asset or balanced funds, is determined by the return target—generally a peer group-based benchmark, and/or an absolute return.

The higher the return target (usually an inflation-plus target), the more risk the fund must adopt, given the positive relationship between risk (as measured by volatility) and return.

Local equity

The main return driver in the long run

Locally, balanced fund portfolios tend to rely heavily on domestic equity to drive performance.  We can see that fewer than 10% of multi-asset funds beat a CPI+3% return target over rolling 36-month periods between mid-2016 and end-2020, when the local equity market delivered 0% or negative real returns (on a 36-month rolling basis) over the same period.

A persistent allocation to domestic equity makes sense based on long-term historical returns.  Over the past 20 years, local equity delivered a nominal return of 13.6%, meaning a real return of 7.7% which would comfortably beat most CPI+ targets (albeit with notable volatility), whereas foreign and domestic cash delivered real rand returns of -2.7% and 2.0%, respectively.

Asset allocation as a return driver

We know that diversification reduces volatility.  By including a large number of stocks in a portfolio, we are able to lower its volatility, while diversifying across asset classes usually leads to a much larger decline in volatility—as the correlation between asset classes tends to be weaker than within asset classes.

Yet these asset classes can be combined in different ways.

Strategic Asset Allocation (SAA) sees asset classes being apportioned according to fixed weights determined by optimising the return of a portfolio using long-run historical return, volatility, and covariance (a measure of co-movement) data.  The portfolio is rebalanced periodically (say, quarterly) to ensure that over time the asset class weights match those of the SAA.

A crucial, but flawed, assumption is that the historical estimates of return, volatility, and covariance will hold in the future.  However, correlation or covariance can be unstable, with both shifting based on underlying market conditions.  During stress periods—such as the global financial or the COVID crises—co-movement between asset classes tends to increase.

A variation is Tactical Asset Allocation (TAA), which allows for deviations from the strategic allocation and sees the portfolio being overweight or underweight a certain asset class.  Given that the TAA references the SAA, the assumption that historical return, risk, and covariance estimates will hold in future is still embedded in the portfolio construction.

In both SAA and TAA, historical return biases dominate—and explain why South African balanced funds have tended to be equity heavy.  While TAA gives the asset allocator more flexibility, it is still anchored to the SAA and, therefore, tends to be static.

Intuitively, rebalancing should limit inherent preference for an asset class, outside of the SAA.  That is because you lower your allocation to previous out-performing asset classes, and increase your allocation to previous under-performing asset classes.

It is evident that more flexibility is needed when it comes to asset allocation.

Consistency in active asset allocation

As asset allocators, one needs to minimise the downside risk to a portfolio’s return, while consistently meeting the return target.  This gives the investor more certainty (but by no means a guarantee), but with the benefit of inflation-beating growth.

Crucially, the stasis needs to be replaced with an active decision-making process, also referred to as Active Asset Allocation (AAA).  This approach doesn’t reference strategic weights as a starting point.  Instead, the risk and return parameters are forward-looking and based on scenario analyses, rather than historical data.

Moreover, a bottom-up approach to selecting asset classes and weights has the objective of meeting the return target with the lowest possible risk.  Importantly, AAA is not bound by periodic rebalancing, as the portfolio is actively managed and can include short-term opportunities across various asset classes.

For example, since 2014 foreign equity has sharply outperformed other major asset classes due to the exceptionally strong US equity performance, as well as the rand’s depreciation.  Yet based on long-term history, foreign equity has underperformed local equity (3.9% versus 7.7% on a real basis).

Recency bias would have skewed a balanced portfolio towards offshore equity, exceeding its return target—but with notable volatility that stemmed from both the equity and the exchange rate components.

A typical SAA portfolio would have fallen short of a typical balanced fund return target of CPI+4%, while active asset allocation would have delivered CPI+5.2%, achieving its mandate of consistent returns that meet the benchmark without a persistent bias towards a specific asset class.

Accordingly, by adopting an active approach to asset allocation, portfolio managers are freed to select better-performing assets while minimising risk.  Unconstrained by fixed weights, they are able to outperform benchmarks on a consistent basis.

Eben Karsten is the chief executive officer at Matrix Fund Managers.