For decades, strategic asset allocation has been seen as the driver of investment portfolio returns. But the old adage that allocation determines 90% of performance is quickly becoming obsolete.
Over the course of 2020, we have seen how the investment world has shifted from a world where falling interest rates drive beta performance to a world where the dispersion of returns increases within classes. assets, regions and sectors. This dispersion is amplified by retail investors who have greater access to markets through supposedly zero-cost investment platforms.
Going forward, in an era of near-zero or rising interest rates, beta will play a secondary role in driving performance. Since the beginning of 2020, three phenomena have propelled the future of investing, pushing it towards more precision-oriented strategies:
1. The pricing mechanism
The combination of near-zero interest rates, fiscal and monetary stimulus, and increased market access among retail investors has transformed the pricing mechanism. Several times over the past year, whether with GameStop or AMC Theaters, price discovery seems to have been thrown out the window. Due to excess liquidity and the behavioral expectation of the “biggest fool”, investors believe they will be able to sell quickly at a higher price. Leverage in public markets has increased: while retail investors were content to trade stocks, thanks to the lower transaction costs of derivatives, many are now acting as marginal buyers through options.
Over the past year, pension funds, sovereign wealth funds (SWFs) and other long-term institutional investors have repeatedly acted pro-cyclically rather than being the buyer of last resort during a downturn. of the market. For example, large pension funds removed tail risk hedges just weeks before the start of the bear market, and some had to sell assets in the midst of the correction to meet their sponsor’s unforeseen liquidity needs.
Removing this “rational investor” pricing mechanism makes it much more difficult to define return expectations for different asset classes. There is uncertainty as to the validity of the prices. This is then compounded by the greater dispersion of valuations between seemingly similar companies: think, for example, of Volkswagen’s valuation catch-up to include the “electric vehicle bonus” in March.
As beta has become more uncertain, expectations around risk measures and correlations have also increased. This then diminishes the usefulness of classic beta-oriented strategies.
2. Private Assets
The growing importance of private asset returns makes it more difficult to determine the risk and returns of portfolios using traditional methods.
Over the past decade, institutional investors have expanded rapidly into illiquid and non-public private market investments in real estate, private equity, private debt and direct lending. There are several reasons for this, some more valid than others: It makes sense to expand the set of investment opportunities and diversify income streams, for example. But the valuation lag and the supposed risk-reducing benefits of market-unpriced assets make little sense. Especially in classical strategic allocation studies, such biases lead to naïve private investments that ignore proper diversification within the asset class.
If not, why are investors turning to private markets? Because there are targeted investment opportunities that cannot be found on listed exchanges. Potentially disruptive industry developments, in particular, are sometimes difficult to capture through mid- and large-cap companies in public markets.
Thanks to greater computing power, knowledge dissemination and outsourcing opportunities, the development of new products in the fields of industrial automation, oncology and behaviors, among others, has become much more easy, given access to intellectual capital and appropriate venture capital.
The potential of these fields will last for a long time. But it’s not until their comprehensive tech developments become broadly investable that they’ll sort out winners and losers while elevating the field as a whole. In the pharmaceutical field, for example, many of the most profitable innovations of recent decades have been developed locally, in bioscience parks. Investing in, say, the top 10 pharmaceutical companies would not have been precise enough to take advantage of these developments.
From antiviral treatments to gene therapies, precise — and risky — investments in companies in sectors ripe for disruption offer more rewards than moving up the public markets risk spectrum. Yet strategic asset allocation often imposes constraints. It can be difficult, if not impossible, to select niche managers with deep ties to the industry in question. Typically, these targeted investment strategies do not fit into top-down investment policies and are therefore discarded. As a result, large institutional investors leave opportunities for returns to smaller players, such as entrepreneurial family offices.
For investors, the larger set of opportunities should outweigh the potential downsides, even after mitigating the overly positive biases of the investment process. Prudent upward-biased portfolio construction techniques should offset concentration risks, and reasonable risk and return expectations could be factored into allocation decisions. Or better yet, public and private investments could be merged into building a single portfolio to improve diversification.
3. Diet change everywhere
Developments over the past year have accelerated the pace of industry transformation. The evolution of a long list of performance drivers now makes it more critical to consider risk on a dynamic and unique investment basis.
Longer-term trends combined with policies put in place to counter the impact of COVID-19 on the global economy have only amplified the effect. Changes in the way people work – offices vs. distant, physical vs. digital, and local vs. global – influence the short-term perception of investments. What will happen to office buildings? How many logistics centers will be needed? How much is a chain of franchised restaurants worth if it can only do home delivery? In the longer term, winners will be differentiated from losers, with some industries emerging more resilient than others.
Governments around the world have all responded to the crisis differently, but most have tapped into the same toolbox and pursued stabilization and compensation through debt issuance. Even when the resulting debt levels are seen as perpetual, policy will need to be normalized at some point to avoid a much more centralized planned economy compared to the pre-COVID era.
At this point, the dispersion within asset classes will increase again. Which regions, sectors and companies have taken more effective long-term measures to prevent capital destruction when pandemic-related fiscal support is withdrawn?
Another market dispersion factor? Emphasis on environmental, social and governance (ESG) factors. Governments have considered various “new green deals” that would provide funding for “green” businesses or projects. Central banks, the IMF and the World Bank have taken a similar approach. From a macro governance perspective, the direction of legislation is becoming clearer, some investments will be better placed than others.
The geopolitical situation is another factor. Increased competition, combined with de-globalization efforts to create more robust supply chains, whether for semiconductors or the production of agricultural commodities, could lead to heightened tensions. A breakdown in global relations could create both risks and opportunities. The Asian economies of the Tiger could see their fortunes decline, while those of Latin America and India could see theirs improve. These growing long-term uncertainties make it particularly difficult to establish a sound strategic asset allocation process and sustain it over the next decade.
The evolving environment and accelerating pace of change will require a deeper understanding of underlying financial and behavioral dynamics, geopolitics and investments. Without a more holistic and practical approach, investors will leave returns on the table, while risking more by reluctantly accepting the risks of economic concentration.
Generating optimal returns in this new era will require investment governance that enables detailed and timely investment decisions. This means a more integrated investment framework and new and different methods of risk assessment.
Sticking to the status quo will only sacrifice performance.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
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