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#Investments — 14.02.2019

Strategic Asset Allocation for 2019 and beyond

Kanol Pal, Strategic Asset Allocation team, CIO Office,Asia

Looking beyond 2019, how can you plan your Strategic Asset Allocation to earn steady returns over a 5-10 year time horizon?

Strategic Asset Allocation

2018 was a volatile year where we saw S&P 500 drop by 20% between September to December, as it came off a high of 2930 to a low of 2351.

The contrast could not have been starker to the previous year (2017) when the US stock market was in a nice uptrend, the index started at 2257 in January and ended the year with a significant increase of 20%.  

Clearly, it can be hazardous to predict the behavior and the expected return of the market in the short term (year on year and even on a shorter time horizon),

But in the long term, it should be relatively easier to predict the expected return of each asset class because of the correlation between risk and return. Over a long term horizon, cash or government bond have a lower return than high yield bond, equity or private equity.

Expected Risk & Return of various asset classes (5 to 10 years investment/time horizon)

Chart 1: Expected Risk & Return of various asset classes (5 to 10 years investment/time horizon)

This “hierarchy” of expected risk/return allows investors to build a portfolio corresponding to his long term risk/return objectives through a strategic asset allocation. It will help avoid some of the behavioural biases of greed and fear.

Trying to define an appropriate asset allocation by forecasting short term returns with market volatilities is extremely difficult to achieve, it is related more to trading than portfolio management.

What is Strategic Asset Allocation ?

Strategic Asset Allocation is about structuring an optimal portfolio in the long term (5-10 years) by asset classes, using long term expected returns while Tactical Asset Allocation aims to take advantage of short term market opportunities by selecting the most relevant securities by asset class.

Strategic Asset Allocation is the most important driver of returns’ stability over the long term. It explains more than 75% of the variability of returns while security selection, tactical asset allocation and market timing all 3 together only explain the remaining 25%1.

So it is useful for private investors to spend some time defining a strategic asset allocation as a complement to short term tactical asset allocation. It will provide them a roadmap to harness returns from various market risk premia over the long term, meet their investment objectives and avoid being “jostled” by short term market fluctuations.

Examples of institutional allocations

Chart 2: Examples of institutional allocations

Strategic Asset Allocation by Institutional Investors

In the institutional world, sovereign wealth funds, pension or endowment funds have a strategic asset allocation framework in place.  They have long term horizon and their objectives are to deliver consistent long term real returns.

Let’s look at the strategic asset allocation of Harvard, Yale and the Norway sovereign wealth fund. They have a long term track record of achieving superior returns with substantial AUM (assets under management). Harvard and Yale have been delivering returns above 10% p.a over the past 20 years2.

Harvard and Yale are endowment funds and their main objective is to deliver regular income to meet university spending policies while preserving the purchasing power of the endowment. Chart 2 shows that they place more weight to alternative investments such as Venture Capital, Private Equity, Natural Resources or Absolute Return.

Norway Sovereign Fund is investing its wealth in oil and gas to safeguard and build financial wealth for Norway’s future generations. The benchmark given to the fund by the Ministry of Finance is to allocate 70% of the fund in Equities and 30% in Bonds, with a progressive diversification into Real Estate. The fund has achieved return of 6% p.a over the last 20 years3.

Strategic asset allocation

Chart 3: Strategic asset allocation in a world of low returns and high risks

Private investors are generally more focused on the short term. There are many market trading opportunities driven by the latest economic, financial or political news. There is nothing wrong with that.

But if they need to build a portfolio with a long term return objective, it is also good to define a strategic asset allocation framework. Long term investing and short term trading can be complementary.

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 diversified portfolio.

Planning your Strategic Asset Allocation

The inputs for expected returns for Strategic Asset Allocation are generally based on more objective long term “market equilibrium” returns and not subjective views.

Market equilibrium returns represent the fundamental values inherent to each asset class, they are more related to structural drivers of the economy and do not take into account short term cyclical factors like the current Fed policy or China’s stimulus package.

For example, the expected return of the equity asset class is based on the dividend yield, a long term capital growth rate (proxied by the GDP nominal growth rate) and a volatility premium.

Over the past 10 years, long term expected returns have been trending down but remain more stable within a range. Secular drivers for long term growth have been in a tug of war: technological innovation has offset some of the drawbacks from aging population and deleveraging.

Diversification and the inclusion of alternative investments have become more important as a 60/40 portfolio would not provide you the same type of returns in 2019 as in 2009. We need to find new asset classes to provide new sources of returns. Today’s portfolio need to be more diversified than before.

Navigating 2019 and beyond

Looking beyond 2019, how would you build your Strategic Asset Allocation for a 4%, 5% or 6% returns over a 5 to 10 years time horizon ?

strategic asset allocation for a 4%, 5% and 6% expected returns

Chart 4: Illustrative examples of strategic asset allocation for a 4%, 5% and 6% expected returns

Market volatility is likely to remain high in 2019 and beyond. Trade wars, Brexit and other political risks, economic growth slowdown are some of the factors that could create short term market turbulences.

To build a portfolio to meet long term objectives, investors should adopt a strategic asset allocation framework: what is the level of expected return and risk over the long term? what are the eligible asset classes? What is the level of liquidity is needed? What is the income required?

It is like having a compass to help navigate market volatilities. It is an important complement to Tactical Asset Allocation and Security selection. Depending on your investment objectives and constraints, a tailor made approach can be made.

1 Source: Strategic Asset Allocation and Other Determinants of Portfolio Returns - Hoernemann, Junkans and Zarate Study, Winter 2005

2 Source: Harvard Management Company - http://www.hmc.harvard.edu/about-hmc/performance-history.html

2 Source: Yale University- https://news.yale.edu/2018/10/01/investment-return-123-brings-yale-endowment-value-294-billion

3 Source: Norges Bank Investment Management - https://www.nbim.no/en/the-fund/return-on-the-fund/