Where our thinking on asset allocation comes from
There are long-term strategic factors that influence the design of a portfolio’s asset allocation, and shorter-term tactical factors that influence the day-to-day management. In this article we explain how our biennial Compendium of Investment and our Investment Strategy Group explore the historic records and evolving secular trends to identify the most significant influences on long-term strategic asset allocation.
The theory behind it
Whilst Sarasin is not a standalone consultant, we view the provision of strategic asset allocation direction as a key element of the investment services we provide. Considering how different approaches and asset mixes can help clients achieve their specific investment objectives is the first part of our investment process.
One of the reasons we have written our Compendium of Investment since the mid-1990s, and run a variety of investment training courses for investors, has been our desire to have proper two-way conversations with our clients. Exploring expectations and asking questions are the basis for thorough ‘suitability’ analysis, which should then lead to a conversation about risk, which is a much more qualitative discussion. While we have used actual numbers and expected drawdowns for particular strategies for many years, we still come across words like ‘conservative’ and ‘medium risk’ when first talking with a prospective client. This can be very subjective as the adjectives used mean different things to different people.
In reality each asset class faces its own risk and one of the best ways to appreciate and calibrate these is to analyse how assets have behaved historically. Our Compendium sets out the characteristics of each of the asset classes we use to build multi asset class portfolios. Together with, in some cases 120 years of data, this historical analysis enables us to model the returns of different strategies: this then illustrates how asset classes behave and guide investors towards the right approach.
A key lesson is that, while history doesn’t tend to repeat itself, it often rhymes. Asset classes have certain embedded characteristics that will define their risk profiles and over years they tend to revert to the mean in terms of valuations and performance, despite significant medium-term dislocations.
However, we recognise that there are moments when historic trends in asset classes or sectors do not mean revert, or when secular shifts are so great that for the timeframes we are studying, a different approach is required. Nearly everything we do requires careful analysis of long-term projections for economic growth and inflation, based on evolving secular shifts. It is these secular shifts that are discussed at our Investment Strategy Group (ISG).
Over the past twenty-five years, our strategic work has resulted in new allocations to corporate bonds and an array of ‘alternative’ investments. We have reduced our UK equity allocation significantly, adopting a much more global approach, with many clients dropping their domestic bias altogether. We introduced derivatives for portfolio insurance, which further developed our ‘target return’ mandates, as well as adding opportunistic protection and income generation for our more classically managed portfolios. Most recently for charity clients, we reduced our exposure to property, bonds and sterling.
Keeping our clients’ strategies fit-for-purpose for the world in front of us has been critical to our long-term success. But what does the investment landscape hold in store for the next decade and how is this reflected in strategy?
How outputs from ISG are reflected in our process
Looking past the pandemic, strategy will need to take account of some enormous secular influences, not least an ageing population, galloping technology, relentless climate change and an evolution in political philosophy.
Our increasing maturity as a population is likely to create a very different pattern for future global economic growth. Since the end of WW2, the world population has more than tripled – in one lifetime. Quite simply, the size of the economy expanded as every year there were more workers earning salaries and spending their money. For investors, this economic expansion was a strong tide that lifted all boats. But whilst lower-income regions including Africa, India and some other Asian countries will continue to add new workers, the much richer developed world no longer has a growing workforce. Only the over-65 population is expanding. So an extraordinary era of growth driven by an unrepeatable demographic stimulus is over. In the next decade we expect average global nominal GDP growth to follow a different, much slower pattern than the post-war average.
Slower economic growth points to slower global profits growth and likely lower equity returns than we have been used to. It also points to lower future inflation, and bond markets have been steadily adjusting to this prospect for many years – to the point that today UK 10 year interest rates have fallen to just 0.3% and 30 year interest rates are at less than 1% (10 years ago they were over 4%). Such low interest rates on bonds leaves little return for long-term investors and diminishes their attraction as an asset class.
It is easy to see why many investors have turned instead to technology companies in their search for good returns. Yes, technology stocks have performed well, but for good underlying reason: digitalisation fundamentally alters the competitive landscape. Artificial intelligence is bringing natural language processing and machine learning so that machines can comprehend, see and learn. The ‘internet of things’ is at a tipping point where connected computers will be embedded into previously unconnected objects (The Economist Intelligence unit estimates that by 2035 1 trillion objects will be connected to the internet). Automation will transform the relationship between people and technology, boosting our creativity, speed, precision and productivity.
The benefits of this technology revolution are accruing not just to the giant platform companies (the ‘FAANGs’), but to a fast-growing ecosystem of companies that provide the essential technology tools to gain competitive advantage and then to those companies in nearly all other industries that use those tools well. One example is in medicine where the ability to process enormous quantities of data and fix single faulty genes is delivering amazing advances. The implication for investment strategy is to really understand these digitalisation and automation ‘themes’ and use them to drive stock selection.
Themes work both ways – they also help identify investments to avoid. The share prices of many ‘blue-chips’, like Citigroup, Marks & Spencer or General Electric, are all lower today than 25 years ago. Studying the long-term disruptive forces affecting businesses can help us steer away from industries struggling to generate sustainable growth.
One key tenet of sound investment strategy is the recognition that the value of financial capital rests on foundations of natural, social and human capital. Too long ignored, the natural capital challenges of climate change and biodiversity loss have reached crisis points. The only solution is a massive shift to a much more resource-frugal economy, requiring substantial changes to consumer behaviour and to the most damaging industries. This change is disrupting not just energy and farming but will stretch right across the equity market as ‘adverse impacts’ are identified and regulated. While one key conclusion for strategy is to include detailed analysis of ESG risks in your thinking, another is to contemplate the opportunity that change on this scale creates. We see adjustment for climate change happening much faster than most and the opportunities create one of our core investment themes (alongside Ageing, Evolving Consumption, Digitalisation and Automation).
COVID-19 has affected the most vulnerable in society especially hard – the elderly have suffered more from the virus; unemployment has disproportionately impacted those on the lowest incomes, often lower-skilled and younger workers; developing countries have not had the resources to cope. On the other hand, policies that have driven-up asset prices have rewarded the wealthy and Wall Street more than ‘Main Street’. This ‘K’-shaped recovery seems politically unsustainable. ‘Levelling up’ was already a concern for politicians before CV-19 and the post pandemic era must fashion a more inclusive future than the past. The primary political objective is now to enable people to find productive jobs. This requires fresh policy thinking to prevent excessive bankruptcies and create growth that puts employment objectives above inflation concerns and austerity.
With interest rates already close to zero, the massive economic shock is pushing economic policy into uncharted territory. Central banks will continue with extreme financial repression measures to prevent deflation – a much greater evil than allowing inflation to exceed their 2% targets. But the strongest economic influence will be from exceptionally large government spending, funded primarily by borrowing. This ultimately raises the risk of ‘fiscal dominance’ where governments override the independence of the central banks by simply requiring them to ‘monetise the debt’ – to create new money to buy the newly issued government debt (advocated by some as “Modern Monetary Theory”, MMT). A series of public infrastructure projects, financial reforms, and regulations worth trillions of dollars are planned, making government a much more dominant player in the economy. But this policy is not without risks, especially in less-stable economies.
There are changes in thinking at a microeconomic level too as shareholder and corporate philosophy is clearly shifting to a more utilitarian approach that balances corporate purpose and profit. The ‘shareholder value maximisation’ mantra popularised by Milton Friedman in 1970 is now being rejected in its purest form. Management were focused on profit with generous share-linked incentive plans. Instead, they are now encouraged to consider employees, customers, suppliers, community, and the environment in their decisions. The benefits may well include a change from a ‘downsize-and-distribute’ management approach that has favoured share buybacks and short-termism to more of a longer-term ‘retain-and-reinvest’ strategy. The long-term outcome may well be a boost to innovation, greater employment stability and less income inequality.
Setting long-term investment strategy requires understanding of the nature of asset classes as well as careful consideration of demographics, technology, natural and social capital, politics and many other factors. Our Compendium of Investment and Investment Strategy Group aim to keep our clients’ strategies fit-for-purpose for the future.