Investors should remember Charles Darwin’s insight that adaptation is the key to survival as the world’s economy and financial markets undergo significant changes.
Such adaptation should begin with strategic asset allocation (SAA), which is the first step in constructing an investment portfolio. The SAA is the default asset allocation for an investment portfolio, and it is designed to provide the best chance of achieving certain objectives over the long term, regardless of any shorter-term fluctuations in the relative valuations of different asset classes. Numerous studies have demonstrated that the SAA drives most of the risk and return of investment portfolio over the long term.
SAA is important for portfolios because it informs the point of departure for the managers, but most of all because it should be designed to achieve certain client suitability goals, whether that be in terms of risk levels or desired returns.
Historically, SAAs are derived from long-term data modelling that analyses how asset classes behave in isolation and with each other, taking account of factors such as maximum drawdowns, standard deviations in performance and tail value at risk characteristics. Based on this analysis, different mixes of asset classes can be selected from those available to a fund manager to create optimal models that match whatever objectives are pre-defined.
Because they are based on long-term data, SAAs should not change too frequently. Annual reviews are ideal to test their appropriateness and make any tweaks using the latest data. They should also be applied by active portfolio managers in conjunction with tactical asset allocation (TAA). These are based on shorter to medium -term views of asset classes that could result in adjustments to portfolios within pre-set limits, increasing exposure to those asset classes considered undervalued and reducing exposure to those deemed overvalued, for example.
Last year was challenging for investors, with central banks sharply tightening monetary policy to counter soaring inflation, concerns over the strength of the global economy and Russia’s invasion of Ukraine. It was the worst year for bonds in a long time. A key principle of SAA is the benefit of diversification and bonds could traditionally be expected to provide defensive ballast when equity prices fell. But last year, both asset classes fell amid the market stress.
As much as 2022 was tumultuous, there are more fundamental changes that have been happening in the world economy and markets for many years. Decades of globalisation have increased the world’s connectivity and inter-dependence, while exponential advances in technology have made financial markets faster-moving and more complex. Sophisticated tools are required to process vastly greater volumes of data and to identify the key factors driving markets.
Perfect hindsight at the beginning of the 2010s would have led an investor to have a bias towards US assets, given the phenomenal performance of technology growth stocks such as Facebook, Apple, Amazon, Netflix, and Google. Going forwards, however, the argument for a diversified and flexible portfolio is stronger than ever. The assets that outperformed strongly over the last decade because of pervading conditions are unlikely to be the consistent outperformers over the next decade as other market drivers come in to play. Markets will shift quickly and their cycles shorten as ever greater volumes of information will be delivered more rapidly and the geopolitical landscape evolves. There will be differences in the direction of fiscal and monetary policy across the world as it becomes more fragmented.
In such an environment, it will be important to have an investment process that can cut through the market noise and respond to market nuances, investing in a diversified range of asset classes, styles and funds that will provide steady returns with neither reliance on any one scenario playing out nor wholesale shifts in allocations.
SAAs in the past have largely been based on analysing the past performances of asset classes, both in isolation and together. Going forward, this will not be sufficient. Investors will need more intelligence and insights to create long-term SAAs.
Several factors will make the next decade’s ‘big picture’ very different to the last one. We are already seeing a less liberated global environment with weaker capital flows and reduced movement of goods and labour. The world will be multi-speed, with national economies behaving differently and monetary and fiscal policies no longer in lockstep as governments deal with their domestic conditions and outlook rather than just following the Federal Reserve.
Furthermore, investors increasingly want their investments to contribute to a better world, supporting the environment and human welfare. This means Environmental, Social and Governance (ESG) factors must be integrated into SAAs.
In adapting to these new realities, an updated approach to SAA will require sophisticated tools and investment managers with the resources, skills and nimbleness to adjust models when necessary. However, it should also be remembered that while everything evolves, the purpose of SAAs remains constant – to inform the long-term direction of portfolios to meet financial goals.
Past performance is not a guide to future performance. The value of an investment and the income generated from it can fall as well as rise and is not guaranteed. You may get back less than you originally invested. This document is issued by Liontrust Fund Partners LLP (2 Savoy Court, London WC2R 0EZ), authorised and regulated in the UK by the Financial Conduct Authority (FRN 518165) to undertake regulated investment business. Some of the Funds managed by the Sustainable Future Equities team involve foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. This is a marketing communication. It should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy. The investment being promoted is for units in a fund, not directly in the underlying assets. It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, forwarded, reproduced, divulged or otherwise distributed in any form whether by way of fax, email, oral or otherwise, in whole or in part without the express and prior written consent of Liontrust. Always research your own investments and if you are not a professional investor please consult a regulated financial adviser regarding the suitability of such an investment for you and your personal circumstances.
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