There were a couple of pieces written in the media in 2016 suggesting that the year represented a tipping point in the shift from active to passive management, both in equities and fixed income markets. Whether or not this is true, when it comes to asset allocation it seems that the period ahead will require even more active management than has been the case in the recent past.
We’ve had an environment that has been supportive of passive approaches to asset allocation in terms of returns. For the most part the “default” allocation has done well: almost any mix of equity and bonds has delivered reasonable returns with reduced volatility, the strength of the US market means that the MSCI World has been hard to beat and most currencies have been stable relative to their history.
The environment has been forgiving of “set and forget” asset allocation
We have noted before that the strength of the bond rally in recent decades has resulted in government bonds delivering returns traditionally associated with more risky asset classes. The chart below shows the returns from the MSCI All Country World equity index against those from the Citigroup World Government bond index over the last ten years.
In contrast to traditional rules of thumb, adding government bonds to a multi asset portfolio to reduce volatility has actually enhanced returns. Moreover, as the below illustrates, it hasn’t mattered too much how much of the safe haven asset has been added. Delivered returns have been relatively similar whether you have had a 70/30 equity-bond mix, 50/50, or a 70% in bonds.
There are signs that this environment is changing, and 2016 could represent a tipping point in the ability of static allocations to achieve the sort of outcomes required by investors. More active approaches may be needed for a number of reasons:
- Volatility and correlation patterns could be changing
A static mix of bond and equity allocation has been great for risk management because government bonds and equities have tended to be negatively correlated and bonds have been less volatile. However, as the charts below illustrate, this dynamic did not hold in 2016.
It is also the case that correlation patterns can, and do, change. The taper tantrum in 2013 provided a dry run of how bonds and equities can easily become positively correlated. Rising rates or increasing inflation pressures in the absence of profits growth can pressure both equities and bonds
- Bond valuations are in uncharted waters
It is true that interest rates and bond yields may have been at similar levels in the distant past (particularly in real terms). But the fact is that in the modern history of finance, and in the histories used by most models on which strategic/passive asset allocations are based, yields have never been so low.
This in itself does not imply significant losses from government bonds in the period ahead; the same argument could have been made many times in the past. However, it is the case that strong capital gains from bonds will be “borrowing” returns from the future and lower yields increase the vulnerability to changes in the regime.
The past could well be even less relevant as a guide to the future than normal and this will challenge simplistic rules of thumb, such as the idea that risk averse investors should hold more government bonds, or that a portfolio can be “de-risked” by holding less equity.
- Equity valuation could become a tailwind rather than a headwind?
Since the financial crisis, the US stock market has outperformed most of the rest of the world. It has benefited in the most part from superior earnings delivery and partly through greater weighting of stocks with “bond proxy” characteristics.
Since the US represents 60% of the MSCI World, this means that it has been harder to beat the MSCI World through country selection, without having a significant proportion of a fund’s overall assets in US equities.
Our view today is that the US market is fairly valued rather than expensive, but there are areas of the market that have been re-rated simply because earnings have been stable, rather than growing. Avoiding these areas that may be vulnerable to a shift in this regime is unlikely for many passive equity asset allocation strategies.
- Divergent policy could prompt even larger currency shifts
Since 2014 there have been meaningful shifts in the currencies of major economies. This comes after a period of relative stability, in which the world’s central banks have shared a common inflation-targeting policy approach.
Big shifts in currencies such as those seen in the second half of the twentieth century do not only impact the returns to overseas investors directly through translation effects. They also influence a country’s inflation dynamics, policy responses, and the earnings of multi-national companies (as we have just seen in the UK post-Brexit). Understanding the interplay of these forces could well be vital and require a more active approach to currency management than has been required since the financial crisis.
As readers of Richars Thaler’s “Nudge” will know, the default position is still an active decision. We have just had a period in which the default, passive option has done extremely well. The arguments for and against a passive approach should not be confused by the recent returns that have been delivered. This is particularly true in the case of asset allocation, where all the signs are that active management could be increasingly important in the period ahead.