EBEN KARSTEN: Active asset allocation improves returns consistency

Multi-asset and absolute return investing go hand in hand, as the enhanced diversification provided by multiple asset classes should limit downside risk. The objective of these funds is to deliver positive real returns, irrespective of market conditions.

In SA, the portfolio composition of multi-asset or balanced funds is determined by the return target, generally a peer group-based benchmark or an absolute return. The higher the return target, usually an inflation-plus target, the more risk the fund must adopt given the positive relationship between risk (as measured by volatility) and return.

Locally, balanced fund portfolios tend to rely heavily on domestic equity to drive performance. Fewer than 10% of multi-asset funds beat a CPI+3% return target over rolling 36-month periods between mid-2016 and end-2020, when the local equity market delivered 0% or negative real returns (on a 36-month rolling basis) over the same period.

A persistent allocation to domestic equity makes sense based on long-term historical returns. Over the past 20 years local equity delivered a nominal return of 13.6% — a real return of 7.7%, which would comfortably beat most CPI+ targets, albeit with notable volatility, whereas foreign and domestic cash delivered real rand returns of -2.7% and 2%, respectively.

Diversification reduces volatility, and by including a large number of stocks in a portfolio we are able to lower its volatility, while diversifying across asset classes usually leads to a much larger decline in volatility as the correlation between asset classes tends to be weaker than within asset classes.

Yet these asset classes can be combined in different ways. Strategic asset allocation (SAA) sees asset classes being apportioned according to fixed weights determined by optimising the return of a portfolio using long-run historical return, volatility and covariance (a measure of co-movement) data. The portfolio is rebalanced periodically (say, quarterly) to ensure that over time the asset class weights match those of the SAA.

A crucial, but flawed, assumption is that the historical estimates of return, volatility and covariance will hold in future: correlation or covariance can be unstable and shift based on underlying market conditions. During stress periods such as the global financial or Covid-19 crises, co-movement between asset classes tends to increase.

Equity heavy

A variation is tactical asset allocation (TAA), which allows for deviations from the strategic allocation and sees the portfolio being overweight or underweight a certain asset class. Given that the TAA references the SAA, the assumption that historical return, risk and covariance estimates will hold in future is still embedded in the portfolio construction.

In both SAA and TAA historical return biases dominate and explain why SA balanced funds have tended to be equity heavy. While TAA gives the asset allocator more flexibility, it is still anchored to the SAA, and therefore tends to be static.

Intuitively, rebalancing should limit inherent preference for an asset class, outside the SAA. That is because you lower your allocation to previous outperforming asset classes and increase your allocation to previous underperforming asset classes.

It is evident that more flexibility is needed regarding asset allocation.

As asset allocators we need to minimise the downside risk to a portfolio’s return while consistently meeting the return target. This gives the investor more certainty (but by no means a guarantee), but with the benefit of inflation-beating growth. Crucially, the stasis needs to be replaced with active decision-making.

We refer to this as active asset allocation (AAA), which doesn’t reference strategic weights as a starting point. The risk and return parameters are forward-looking and based on scenario analyses rather than historical data. Moreover, we take a bottom-up approach to selecting asset classes and weights, with the objective of meeting the return target with the lowest possible risk. AAA is not bound by periodic rebalancing, as the portfolio is actively managed and can include short-term opportunities across various asset classes.

Since 2014 foreign equity has sharply outperformed other major asset classes due to the exceptionally strong US equity performance, as well as the rand’s depreciation. Yet, based on long-term history foreign equity has underperformed local equity (3.9% vs 7.7% on a real basis). Recency bias would have skewed a balanced portfolio towards offshore equity, exceeding its return target but with notable volatility that stemmed from both the equity and the exchange rate components.

A typical SAA portfolio would have fallen short of a typical balanced fund return target of CPI+4%, while AAA would have delivered CPI+5.2%, achieving its mandate of consistent returns that meet the benchmark without a persistent bias towards a specific asset class.

By adopting an active approach to asset allocation portfolio managers are freed to select better performing assets while minimising risk. Unconstrained by fixed weights, they are able to outperform benchmarks consistently.

• Karsten is Matrix Fund Managers CEO.