The perceived importance of asset allocation in driving investor returns faded from the 1990s as a result of high overall returns from most asset classes and relatively high correlations between bonds and shares.
However, the dismal returns of the last decade from global shares, a relatively constrained overall return outlook, increasingly wild swings in share markets and the return to more volatile economic cycles is serving to highlight the importance of asset allocation.
The AMP’s chief economist, Dr Shane Oliver looks at the renewed importance of an old dilemma for investors.
Everything comes in cycles, and one of the big swings in investment management relates to the perceived importance of asset allocation, i.e. the exposure an individual or fund has to individual asset classes, e.g., global shares, Asian shares, Australian shares, global bonds, unlisted property, cash, etc.
Through the 1990s and into the last decade the investment management industry increasingly moved away from worrying about asset allocation to focusing on manager selection at the asset class level.
This partly reflected the experience of the 1980s and 1990s, where most asset classes did well and so asset allocation was seen as less important and many thought it was too hard anyway.
This is all changing with the global financial crisis and continuing gyrations in investment markets, coming on the back of a decade of poor returns from traditional global shares, providing a reminder of just how important asset allocation is.
As a result asset allocation looks to be making a big comeback.
What is asset allocation?
First some technicalities.
The return a diversified fund or mix of assets generates will essentially be a function of three things:
- The fund’s medium to long term allocation to each asset class (i.e. shares, bonds, etc) and hence the market return they generate – this is usually referred to as the fund’s Strategic Asset Allocation (or SAA);
- Any short term deviation in the asset mix away from the SAA – this is traditionally referred to as Tactical Asset Allocation (or TAA); and
- The contribution from active management of the underlying asset class portfolios.
This is often referred to as security selection.
In the past this was largely undertaken by just one manager but over the last decade a range of fund managers have been used in each asset class.
While various studies show the last two components are of similar importance depending on the period, there is general agreement that the first component – i.e. the strategic asset allocation of a fund – is the key driver of the return an investor will get.
And of course its importance will rise even higher once any tactical asset allocation is allowed for as well.
In fact, if you believe active management will add no value, or the fund only invests in indexed funds, then asset allocation will drive 100% of the return.
Asset allocation took a back seat from the 1990s
During the 1990s and into the last decade asset allocation seemed to fade in importance relative to security selection and picking managers.
There were several reasons for this.
First, real returns from shares, bonds and most other asset classes were very high during the 1980s and 1990s, reflecting the powerful tailwinds of falling inflation, deregulation and globalisation.
Against this backdrop there seemed to be little need to worry about asset allocation.
Buy and hold – virtually anything – worked very well.
“Time in, not timing” became the mantra because it worked seemingly easily.
Second, there was thought to be little scope for asset allocation to enhance returns because the main asset classes of bonds and shares seemed to move pretty much together anyway.
(1 For articles on the importance of asset allocation see R.G. Ibbotson. “The Importance of Asset Allocation”, Financial Analysts Journal. Mar/Apr 2010).
This was because they were largely being driven by a common factor which was the fall in inflation and inflationary expectations that occurred from the early 1980s.
This drove a fall in bond yields (and hence high returns from bonds) and a rise in price to earnings multiples (which boosted equity returns) and as a result the returns of equities and bonds were positively correlated through much of the 1980s and 1990s (see the next chart).
Third, there was a perception that it was just too hard to enhance returns by varying the asset allocation of a fund.
The track record of traditional diversified funds being able to add value by tactical asset allocation was perceived to be poor.
This was seen to be a reflection of the traditional committee based approach to asset allocation where consensus and group think led to weak decisions and committee members were part-timers (usually asset class managers) and lacked the skills to assess the relative return potential between asset classes.
Also, it was felt that undertaking asset allocation over just a handful of assets meant it lacked sufficient breadth to be able to add value.
On top of this, undertaking asset allocation was seen as expensive as it meant buying and selling physical exposures to assets.
Finally, there was a general faith in the view that investment markets we
