Is Asset Allocation broken?
Shannon Currie from Perception Support discusses her views on Asset Allocation.
One of the most weary refrains within our profession must surely be – ‘that past performance is no guide to the future performance.’
And yet in other arenas, significantly global economics and politics, the mantra everyone believes in is ‘that history informs our present and our future’.
On a personal level I believe we are the sum of books we have read, the stories we tell ourselves and the people we have met – all of which is necessarily rooted in our experience and by how we choose to interpret the experiences of others.
As a profession, surely then it is necessary for us to take with us a guide from the past in the form of the performance of markets, how they act in times of volatility and how volatile the individual constituents can be. Would it not be lunacy to ignore these when planning for our clients’ financial future?
At its most basic isn’t that what asset allocation is? Looking at past patterns of behaviour in volatility and returns, how assets interact with each other and using this as a guide for their future conduct.
In recent discussions with advisers/planners around the country, one of the most painful conversations was how the asset allocation model must be broken. The markets had left advisers and clients reeling.
We had carefully explained to our clients the value of spreading investments across various asset classes, often drawing squiggly lines which zig and zag to illustrate one market going down while the other was going up. Patiently explaining that diversification was key and we were protecting them by not putting all their eggs in one basket and yet....
In the truly awful moments it felt like all markets had imploded like a soufflé.
The conclusion being - what then, is the point of asset allocation? Is it a broken toy in an Adviser’s tool box?
I should warn you first of a personal bias - I am MD of Independent Edge – a provider of independent asset allocation, risk profiling and virtual investment committee services. I would believe in asset allocation, wouldn’t I?
Whether it is flawed or a 100% right is up for debate, how we use it and how we communicate it to clients is also up for debate – but the thought of having no process or DIY approach, doesn’t bear thinking about.
Well, is asset allocation flawed? Let’s counter a question with a question – what is it we expect asset allocation to do?
If we think that it means a client’s portfolio will never go down – then yes, it isn’t going to work for us – nothing will, except perhaps to have client’s cash in high yielding, government secured banks, split into chunks of no more than £50,000 each, in a permanently low inflation environment. What are the chances?
If we are happy that asset allocation is the result of a deliberate process to allow us to trade return for risk and so help to protect from the worst of the volatility and losses, then yes asset allocation will work for us, and yet it is flawed – for instance, correlation between assets is not static, it varies considerably over periods of time and no such thing as perfectly uncorrelated assets exists.
Remember the behaviour of an asset class is not defined by its relationship to other asset classes but rather by its behaviour in response to external events ie. Inflation, War, Recession etc.
But we do know that over the long term, cash and fixed interest have a low correlation with property and equities.
The clue is time horizon – using shorter term periods to extrapolate into the future without placing it in the context of longer time averages can lead us to grossly over - or under -estimate risk and returns.
In essence, this is what we are seeing now – a reaction to what has happened over the short term without the context of the longer time horizon. And I am not just referring to recent poor markets but also the exuberance of the previous decade/s, which has lulled us into an expectation that markets can go on forever with double digit returns when single digit returns are more like the long run average.
What this means in real life is yes, adopt asset allocation as a core process for looking after client assets but we also need to apply common sense to how we adapt asset allocation in our business. It is about education and communication of expectations - not just for our clients, but also for us.
This leads us to how we use asset allocation. I don’t mind which asset allocation tool you use – just don’t rely on the old-fashioned hit and miss approach of predicting which asset class is best next year.
My wish list would be that the tool should be independent of provider biases and tweaks and is the result of a deliberate process with long run statistics (preferably of the UK market) based on correlation as well as the risk and return numbers.
I would also wish for a strategic approach to asset allocation.
Two reasons for this – philosophically I believe this is more effective for your clients and practically it will be more effective for your business and clients. The reasoning behind this is that strategic asset allocation does not try to work with or against the wind – the theory behind it is to keep exposure between the different assets as constant as possible. Any attempt to time the market will, at best, add trading and transaction costs (to clients and to your business) and could lead to unstable returns and your clients missing some of the best returns. Interestingly, the statistic for missing the 20 best days has been updated to January 2009, and includes the 20 worst days. If you missed the 20 best days in the UK stockmarket from December 1980 your return would have been around 240%, if fully invested you would have achieved more than 700%. Source: Schroders, Lipper. Data from 31/12/80 to 15/01/09.
Tactical asset allocation seeks short term market imbalances, trying to ride the high waves while avoiding the worst lows – unfortunately investor psyche isn’t consistently capable of this. Additional transaction costs and inherent unpredictability of prices means this adds up to an expensive strategy for you and your clients.
That isn’t to say that you shouldn’t consider a tactical overlay but you can see that anything other than a core strategic approach to asset allocation could entangle your business in administrative knots, expose you to more liability for timing decisions and be an expensive approach.
Finally, communication to our clients, advisers and staff and Regulator and Ombudsman matters.
Let’s deal with the easy one first, communicating this to our Regulator and the Ombudsman. As part of the TCF process, the FSA spent time at recent roadshows going through investment strategies and the question ‘what is strategic asset allocation’ was an important one – if only, because a small number of people in the room were able to answer it.
We are not expected to have degrees in economic sciences and to be able to discuss the intricacies of fat tails, black swans and the butterfly effect with Nassim Nicholas Taleb. We are expected to understand what our clients need, have a basic understanding of the concepts and reasoning behind asset allocation and how we expect it to assist in minimising volatility of clients’ investments.
If we decide not to play then we really need a good reason, as we are flying in the face of academic research dating back to Markowitz’ first publication on the theory of portfolio allocation in 1952 winning him the Nobel Prize in Economic Sciences as well as numerous academic studies by some of economics’ most eminent brains.
And if it turns out the theory of asset allocation is the biggest fakery since the Madoff funds – it will be little consolation, but it’s not entirely our fault gov!
Communicating to clients should just be a natural extension of what we communicate to advisers and staff.
If our advisers and staff do not believe in, feel comfortable with or fully understand what we are communicating to clients, this creates angst and conflicted messages.
We all know how difficult it is to explain a new subject until we thoroughly understand it ourselves – ever tried to explain the off-side rule!
Spending the time educating ourselves and understanding what it is we believe in – Our Investment Philosophy – will feed through to our clients.
And it’s not just about what we believe the asset allocation process is. The exploration of our beliefs here will lead us to a well thought through approach and the resulting discipline introduced to our businesses can only have a positive impact for us.
From a practical point of view this may lead us to review how often we report to our clients and what it is we report. Is it about the performance numbers or is it reassurance that they are still on track to attain their financial dreams?
It is very difficult for clients to see valuations which show performance swings from quarter to quarter when we are encouraging them to plan for a comfortable retirement in 20 years time. If I were travelling the 630 miles from London to Skye it would be the equivalent of pulling off every 7.87miles to measure where I had travelled from. I think most people would refuse to travel with me – don’t you?
So, is asset allocation broken? Well, the whole subject of investment practice and methodology has been lacking in our curriculum and for many it has been a case of teaching ourselves and piecing information together as we go.
This has meant that, on occasions, we may have applied it or communicated it in a way it was not designed for and the recent crises of confidence could lead us to throw the baby out with the bathwater or even worse, constantly pull the sapling out by the roots to check if it is growing.
However, with more resources and growing professionalism in this area I am pleased to see more discussion and debate on this subject. I hope this article has provided you with space to step away from the emotional debate and to decide your Investment Philosophy on this subject for the good of your clients and your business.