Strategic-A Educational Series

How to get steady returns over a 5-10 year time horizon in a volatile market??

• 2019 marks the best start for the market in 13 years after a very volatile 2018. However, for many investors, last year was a painful year with most, if not all, asset classes registered negative returns

• No doubt that it is never easy to predict the behavior and the expected return of the market, especially in the short term (year on year and even on a shorter time horizon).

• Nevertheless, in the longer term, expected return of each asset class is more predictable, thanks to the correlation between risk and return.

• Over a long-term horizon, cash or government bond tend to have lower returns than high yield bonds, equities or private equity (as shown in the chart below).

• This “hierarchy” of expected risk/return allows investors to build a portfolio corresponding to their long term risk/return objectives through strategic asset allocation. This also helps investors to be more discipline in investing, avoiding some of the behavioural biases such as “greed and fear”.

• Therefore, steady returns are achievable over a 5-10 year time horizon even the market is very volatile!

What’s the difference between Tactical Asset Allocation & Strategic Asset Allocation?

• Strategic Asset Allocation is about structuring an optimal portfolio with an aim to achieve clients’ targeted portfolio returns or risk levels in the long-term (5-10 years), based on long-term expected returns of different asset classes.

• Tactical Asset Allocation aims to take advantage of short-term market opportunities by selecting the most relevant securities at the “right” moment.

• According to historic analysis, Strategic Asset Allocation is the most important driver of return stability over the long term. It explains more than 75% of the variability of returns, while the other three elements, namely security selection, tactical asset allocation and market timing together only account for the remaining of less than 25%.

• A lot of private investors only focus on short-term market opportunities but miss out this biggest determinant of portfolio returns. Therefore, it is well worth spending some time to define clients’ own strategic asset allocation as a complement to their short-term tactical asset allocation.

This not only provides clients a roadmap to harness returns from various asset classes over the long-term in order to achieve their investment objectives, but also avoids being “jostled” by short-term market fluctuations!

Harvard & Yale endowment funds delivered returns over 10% p.a. over past 20 years. Can the same apply to private clients?

• In the institutional world, sovereign wealth funds, pension funds and endowment funds all have a strategic asset allocation framework in place, with their objectives to deliver consistent returns in a long-term investment horizon.

• For Harvard and Yale endowment funds, their main objectives are to deliver regular income to meet the university spending policies while preserving the purchasing power of the endowment. Both endowment funds have a long-term track record of achieving superior returns above 10% p.a. over the past 20 years with substantial AUM (assets under management).

• The chart below shows Harvard and Yale endowment funds’ strategic asset allocation. They have a very well diversified portfolio with allocations to alternative investments such as venture capital, private equity, natural resources or absolute return strategies. Also, they don’t time the market for short-term opportunities!

• Private investors are generally more short-term focused. No doubt there are many short-term trading opportunities driven by the latest economic, financial or political newsflows. Of course there is nothing wrong with that.

• Having said that, long-term investing and short-term trading can be complementary. It is always good for private clients to define a strategic asset allocation framework with an aim to achieve their long-term return target. The fundamental idea behind strategic asset allocation is to use diversification in the most efficient manner and maximize performance at a constant risk over the long run.

• Unless you are a great stock-picker like Warren Buffet, it is difficult to be right all the time in the markets, thus the need to have a strategic asset allocation like Harvard and Yale endowment funds to achieve consistent returns in the long-term!  

How sovereign wealth funds achieve returns of 6% p.a. over the past 20 years?

• Norway has a circa ~USD 1 trillion sovereign wealth fund (“The Oil Fund”). Its objective is to ensure responsible and long-term management of revenue from Norway’s oil and gas resources so that this wealth benefits both current and future generations.

• The strategic asset allocation given to the Fund by Norway’s Ministry of Finance is to allocate ~70% of the Fund in global equities, ~30% in global bonds, with a progressive diversification into real estate. The Fund has achieved return of ~6% p.a over the last 20 years¹.

• China Investment Corporation (CIC) is China’s sovereign wealth fund. The Fund has grown from USD 200 billion registered capital in 2007 to USD 940 billion (as of May 2019)². Apart from allocations to traditional equites and fixed income, the Fund has almost 40% exposure to alternative assets. The Fund has returned ~6% p.a. over the past 10 years³.

• The fundamental idea behind Strategic Asset Allocation is to use diversification in the most efficient manner over the long run. Investors can enjoy positive compounding and earn the asset class risk premium in a longer term horizon. In summary, the longer our time horizon, your probability of making positive returns increases dramatically. Hence, the sovereign wealth funds can achieve steady returns in the long term!

Can we build a portfolio with expected return target over a 5-10 year time horizon?

• Yes! Strategic asset allocation can help clients to build a portfolio with targeted expected return over a 5-10 year investment horizon

• Chart below shows the optimized strategic asset allocation of three different portfolios with three different expected returns targets (4%, 5% and 6%, respectively).

• For instance, comparing portfolios with 4% and 6% targeted expected returns, the one with a lower targeted return has double exposure to corporate bonds, government bonds and cash & deposits, while the one with a higher targeted return has more exposure to direct real estate and private equity. 

• Market volatility is expected to remain high in 2H 2019. Trade tensions, Brexit and other geopolitical risks, as well as concerns over economic growth slowdown are some of the factors that could create short-term market turbulences.

• Private clients should adopt a strategic asset allocation framework to build a portfolio that meets their long-term expected return objectives.

• A tailor-made strategic asset allocation is like a compass to help clients navigate market volatilities!