The principal objective of investing is simple: earning a return in excess of cash that compensates the investor for the risk taken. The higher the perceived risk, the higher the realised return should therefore be. This means that any investment is essentially an exchange of risk in anticipation of an unknown but somewhat predictable payoff. This can be a more complex process for multi-asset investors, whose portfolios may be built not only with equities and bonds, but with asset classes as diverse as private equity, private credit, real estate and infrastructure, just to name a few.
Across our multi-asset fund range we endeavour to allocate capital to those asset classes we feel offer the best balance of risk and return, and away from asset classes where we feel the returns on offer do not adequately compensate us for the risks. Attempting to analyse and quantify the balance of risk and return for each individual asset class is therefore crucial in making informed investment decisions, however the process of determining an optimal asset allocation can appear daunting in the face of the breadth and complexity of the universe of financial instruments.
Bringing order to the chaos
Our Investment Strategy Group (ISG) and Investment Policy Committee (IPC) help bring order to the chaos. The former seeks to define the long-term thematic backdrop that influences our investment decisions and drives the selection of asset classes in our strategic benchmarks, whereas the IPC determines the tactical asset allocation of portfolios and where we allocate risk. Together the ISG and IPC can address the apparent complexity of the task of asset allocation effectively by focussing on the long-term thematic backdrop that will shape the investment landscape over the coming years.
The IPC also helps us avoid taking unnecessary risk. For example, when the sheer magnitude of the COVID-19 fallout became more apparent in the latter half of February the IPC moved quickly to reduce an overweight equity position across balanced funds. We reduced or sold positions in stocks exposed to global travel, selected banks, energy, emerging markets and Asia. With the proceeds, we added to our already larger than normal cash balances. This has helped dampen the impact on our clients’ investments.
The importance of valuations
Having established our long-term thematic approach, we particularly focus on investments where we believe the wider investment community underestimates the longer-term outlook. This highlights the importance of market valuations in our decision-making process. Understanding where price fluctuations have created investment opportunities is an important focus of our asset allocation process. As such, we invest in areas where the current valuation does not accurately reflect the underlying fundamentals. This disciplined approach towards valuations is a crucial aspect of our multi-asset investment process, regardless of whether we consider individual securities or asset classes as a whole.
Ultimately history has taught us that asset valuations are a critical driver of returns; low asset prices relative to the fundamentals tend to translate into higher returns in the future. Through identifying those assets, we can skew the balance of risk and return in our favour. The obvious question then is which measures of value investors should consider? The answer is that no one single measure is perfect. For example, some of the most widely used measures are the dividend yield, cash flow yield, or perhaps the most popular, the earnings yield. They compare next year’s expected dividends (or earnings or cash flow) to today’s share price. The issue with simplistic valuation measures such as these is that they can signal attractive value opportunities when the long-run fundamentals suggest otherwise. Ultimately earnings tend to be cyclical, therefore just focussing on one year’s worth of earnings may not give us the full picture. To overcome this, investors can compare today’s share price to an average of earnings to control for the impact of the business cycle. This cyclically adjusted price earnings ratio, or “CAPE” was originally popularised by US economist Robert Shiller and today forms an important part of our asset allocation process. Consistent with this approach, the chart below depicts initial valuations based on Shiller’s CAPE and subsequent five-year inflation adjusted returns of the global equity index since January 1980. We can take away two conclusions from this. First, there is a clear relationship between equity market valuations according to CAPE and realised returns. Generally speaking, the lower the valuation, the higher future returns are. Second, the current level of CAPE is historically consistent with a positive real return on equities over the coming five years. In fact, there were only very few instances over the past 40 years when subsequent global equity returns were negative given today’s starting valuations.
How to choose which asset to invest in
Of course, this is only one valuation measure, but it provides us with valuable insights as to the attractiveness of equities as an asset class. It does not, however, provide us with much information how this compares to other asset classes. After all, most measures of valuation can only reliably tell us how asset class valuations compare to their own history, but not how they compare to one another. However, as part of our asset allocation process we must assess the relative attractiveness of various asset classes. One commonly used way of doing so is through assessing risk premia. As we noted above, investing in its most basic sense is just the practice of committing capital in exchange for an uncertain payoff in the future. A risk premium thus quantifies the excess return investors can expect by investing in assets that are perceived as higher risk. The most widely used of those measures is the equity risk premium, or ERP. In its most basic form the ERP can be defined as the excess return of equities over government bonds, hence the higher the ERP, the more attractive equities are compared to bonds. Of course, the same exercise can be conducted across other asset classes, or other risk premia such as country risk or liquidity risk. For the purpose of this article however we will focus on the traditional equity risk premium shown in figure 2, alongside the subsequent realised relative return for equities compared to government bonds. Again, we can draw a number of conclusions from this that inform our asset allocation. First, over any medium to long-term time horizon, our own estimate of the ERP has been a reasonably good predicter of subsequent relative returns over bonds. Secondly, the price swings in financial markets make it conceivable that value opportunities do appear from time to time, especially during times of recessions and fear over the economic outlook. This was evident during the global financial crisis of 2007/08, or even the European debt crisis of 2011/12 when the risk premium on equities briefly rose into double digits. With the benefit of hindsight, we know that investing in the equity market at this time turned out to be exceptionally rewarding. We are not quite seeing those opportunities today; however, we think returns available on equities are still attractive, in particular when considering a backdrop of record low interest rates and bond yields.
This ties in with our ISG’s longer term view on the investment landscape – central banks will continue with extreme financial repression measures to prevent deflation – a much greater evil than allowing inflation to exceed their 2% targets. They will use their full toolkit: interest rates at 0% (in some cases negative), likely for 3-5 years; quantitative easing (QE) to reduce short-term government, company and mortgage borrowing costs; forward guidance and ‘yield curve control’ to keep long-term borrowing costs low. At the same time, demand for return-generating assets has not changed because of the COVID-19 crisis, if anything it has risen, and with bond yields likely to remain lower for the foreseeable future there is now an even larger shortage of investible assets, fuelling the demand for real assets such as equities further and leaving us increasingly optimistic on the outlook for the global equity market.
What are the real-life implications for our funds?
Across our range of multi asset funds, which include our GlobalSar range as well as our Endowments strategies for charities, this has meant that we have been selectively adding to equities over recent months, focussing on best-in-class companies where we feel the COVID-19 crisis has created opportunities for long-term investors. In addition, at the height of the turmoil in financial markets in March, we seized the opportunity to increase our allocation to high-quality, investment grade corporate credit. While the prices of those bonds fell dramatically in March, central banks across the developed world were quick in assuring the market that widespread credit defaults will be avoided, which for us created an opportunity to buy at depressed prices, thereby skewing the balance of risk and reward in our favour. Looking ahead we feel that the environment will remain supportive for risky assets; ultimately the global economy is now in the recovery phase, while central banks and governments will do everything in their power to avoid the recovery from stalling. We balance our preferences for equities and corporate bonds with investments in areas that should dampen volatility should the economic outlook worsen again. We still retain some modest exposure to government bonds, and have been steady buyers of gold throughout 2019 and early 2020, and retain our positions today as a hedge against aggressive new easing from central banks.
It is never advisable to base investment decisions on just one single measure or indicator, and any investment approach, including the valuation approach discussed in this article, needs to be considered in the context of other important insights in the construction of multi asset portfolios. These include factors that influence returns over shorter horizons, such as the overall market sentiment and the macroeconomic environment and outlook. However, a formal asset allocation approach avoids doubling up on macro bets and tries to exploit relative value between asset classes. This approach has served us well when constructing our range of multi-asset funds over many years.