A traditional asset allocation split is unlikely to produce stellar returns over the coming years, according to strategists at Pictet Asset Management, who argue that investors need to ‘lower their sights or change their approach’ in the current environment. 
One of the tried and trusted ways to build a balanced portfolio has been to implement a 60/40 split between stocks (largely those drawn from the developed world) and fixed income (often with a bias towards government bonds, also usually from the developed world).
This approach has proved to be generally successful for large chunks of the past. As a simplified example, a portfolio with a 60 per cent weighting to the FTSE All Share and 40 per cent to the Bloomberg Barclays Sterling Gilts index has generated a 269.98 per cent total return over the past 15 years.
Performance of portfolio vs indices over 15yrs
Source: FE Analytics
While the 60/40 portfolio has made a lower return than the FTSE All Share, the addition of government bonds has resulted in a much more favourable risk profile with its annualised volatility of 7.68 per cent and maximum drawdown of 21.21 per cent being half that of UK equities.
However, a recent note from Pictet Asset Management’s strategy unit suggested that following this approach might lead to investors missing out on returns over the years ahead.
“Lower your sights. Or change your approach. This is the choice facing investors over the next five years. For those who plan to remain faithful to the traditional portfolio building blocks of developed world stocks and bonds, a new reality will unfold: returns will be lower – possibly much lower – than they have been in recent years,” the team said.
“According to our analysis, a portfolio composed of US, European and Japanese financial assets will struggle to generate a real return of above 1 per cent per year in US dollar terms.
“The bond and stock markets of economically advanced nations will no longer be able to rely on central bank largesse; they will also have to contend with sub-par economic growth, a shifting political landscape and stubbornly high public debts. And if that were not challenging enough, valuations for many developed-world stocks and bonds are already at historically high levels.”
So where should investors be focusing their near-term attentions if the prospects for the developed world appear clouded?
Pictet’s strategy unit said “prospects are brighter for investors prepared to move a little beyond the mainstream” and highlighted a number of areas that look attractive from here.
“Emerging market assets – which have struggled over the past five years – appear to be in better shape than their developed counterparts,” it continued.
“These regions benefit from superior economic prospects, institutional reforms and lower asset class valuations. A weakening of the US dollar should provide an additional boost.”
Pictet’s five-year asset class returns forecast, annualised
Source: Pictet Asset Management
The above chart shows the extent to which the group expects emerging market assets to outperform on an annualised basis. In fact, it thinks developed world stocks could return of around 3.5 per cent per year in local currency terms – half their average over the past 20 years.
Factors such as higher inflation, less accommodative monetary policy, modest economic growth and the emergence of more populist political agendas in the US and parts of Europe are expected to hold back developed-market assets.
In contrast, Pictet’s strategists said the emerging world is “one bright spot in the equity market” and predicted its stock markets have the potential to deliver double-digit annualised returns over the next five years.
This is largely down to the effect of a weaker dollar – which has historically heralded strong performance for emerging market equities.
Pictet said the end of the dollar bull market will be beneficial to emerging markets for two main reasons: reduced capital outflows and lower inflation. Furthermore, a number of emerging countries, such as India, Brazil, Indonesia and Saudi Arabia, are implementing structural reforms that should boost their growth potential.
Of course, emerging market equities are likely remain riskier than the developed world, especially if the US follows a protectionist agenda or China’s growth stutters. In order to mitigate this, the strategists suggested allocating countries with a large domestic economy, low levels of public debt and a relatively young population – such as India and Indonesia.
“Retrench from developed world stocks, allocate more capital to emerging market equities and take a sector-by-sector approach when sizing up investment opportunities,” Pictet said.
“Based on our forecasts for stocks, this is the approach we believe investors should follow over the next five years if they are to secure mid-to-high single-digit inflation-adjusted returns.”
Other niche areas of the equity market the group suggests investors may want to consider are certain frontier markets – but only if they can accept higher risk – and sector-by-sector opportunities such as ‘disrupters’ in the tech space and non-oil commodities companies that might benefit from a weaker US dollar, controlled supply and an acceleration in infrastructure spending in developed economies.
Meanwhile, Pictet’s strategists highlight alternatives as another area for those looking to move away from the traditional asset allocation mix.
Pictet’s five-year alternatives returns forecast, annualised
Source: Pictet Asset Management
“Alternative investments such as hedge funds and non-oil commodities – assets whose returns are not highly correlated with bonds and stocks – should also form a bigger part of investors’ portfolios,” it said.
As mentioned above, the group expects several raw materials to rise on the back of weaker dollar but it thinks that gold should perform especially well.
“A weaker dollar should provide a strong fillip for raw materials in general, while political risks – in the shape of Brexit and an unpredictable US administration – and a pick-up in inflation are likely to boost gold in particular,” the group said.
“Indeed, gold will be the star performer according to our forecasts. We expect the price of gold to rise by an average of 8.5 per cent a year over the next half a decade, which would take it back up towards $1,900 per ounce – in sight of the record highs scaled back in 2011.”
Despite some recent issues in the space, Pictet Asset Management continues to like hedge funds, arguing they offer some of the best return/risk profiles of the major investment strategies.
“The low prospective returns offered by traditional asset classes mean that alpha rather than beta will be the main source of portfolio returns in the years ahead. In an environment we expect to be characterised by higher financial market volatility, market-neutral hedge funds look particularly attractive, especially as alternatives to cash or bond allocations,” it said.
“We forecast hedge funds could return 3.3 per cent per annum over the next five years, which would mean they deliver equity-like performance but with less than a third of the volatility of stocks.”
Real assets such as US property could also be attractive, as the group thinks returns here could beat equities. While it concedes that some parts of the commercial property market look “frothy and overleveraged”, the high initial yields on offer and inflation-hedging characteristics make property on the whole look like an attractive investment over the next five years.
While it forecasts private equity to outperform equities over the next five years, Pictet believes the scale of its excess return is like to fall “well short” of its historical outperformance. This is down to relatively stretched valuations and a lack of attractive opportunities, meaning it is not as compelling as it once ways.
Summing up its view on the need to move beyond a 60/40 asset allocation, the group concluded: “The next five years, then, present investors with a dilemma. Place your faith in mainstream bonds and stocks but accept a lower return. Or take the riskier route and venture into less familiar terrain. On balance, the second option makes more sense.”