Switching from more sophisticated asset allocation strategies into simple passive approaches could well be “short-sighted”, according to Hermes’ Tommaso Mancuso, whose research suggests that returns from the former are cyclical.
This comes as an increasing number of investors have switched into passive strategies, as many of the more complicated multi-asset funds have struggled since the 2008 financial crisis.
However, Mancuso – who is head of Hermes multi asset – warned in his latest white paper that it could be dangerous to rotate between styles of multi-asset investing based on which has performed better over the medium term.
“In the context of multi-asset investing, the crucial question is whether active asset allocation and complex investment universes have had their day, or whether their relatively poor performance in recent years has just been temporary,” he said.
“If it’s a case of the former, moving from a broadly active to passive allocation and from complex to simple universes should continue to pay off. But if it’s the latter, such a decision could be short sighted because it would involve significant timing risk.”
Of course, the multi-asset category encompasses numerous approaches, from hedge fund-like targeted absolute return funds to diversified growth strategies and static asset-weighted approaches.
Performance of sectors over 5yrs
Source: FE Analytics
Mancuso pointed out that, while the mandates of funds in this space differ greatly, they all derive from the decades-old 60:40, equity-bond approach to investing.
As strategies have aimed to beat this approach through expanding their asset class universe or timing assets through more complex trades, the head of multi asset’s research suggests that these more sophisticated funds are cyclical as opposed to remaining stable over time.
To reach these findings, he created quantitative strategies and back-tested the performance of multi-asset funds from January 1996 to June 2017 (this time frame encompasses three distinctive points for markets: pre-financial crisis, the throes of the financial crisis and the use of quantitative easing).
Mancuso focused on 10 strategies – five of which were deemed to be “simple” as they invest in two asset classes, and the remaining five of which were classed as investing in an “expanded” universe and adopt more complex approaches.
Within the “simple” and “expanded” brackets, the head of multi asset divided them into five broad asset allocation categories: passive, risk parity, mean reversion, momentum and mixed active allocation.
These strategies were analysed based on overall performance, their isolated value generated from either an expanded universe or an active allocation approach, and the value of combining an active approach with an expanded universe.
“Comparing the results across asset universes, we note that the strategies investing in the expanded universe produced higher returns across all asset allocation methodologies combined with, in most cases, a lower level of risk,” Mancuso explained.
“Interestingly, even for the passive approach, the expanded universe would have delivered significantly higher risk-adjusted returns than the simple universe.”
However, the head of multi asset said this is not simply the result of broader diversification. In fact, his research showed that the simple universe had a negative cross-asset correlation of 0.26 relative to average benchmark weightings across the market area, while the average correlation of the expanded universe was a positive 0.17.
“Comparing the results across investment styles, we note that mean reversion and momentum [styles] deliver higher returns than risk parity and passive,” Mancuso continued. “From a risk (i.e. volatility and drawdown) perspective, risk parity and momentum produce better results, with mean reversion and passive being the worst scenarios.”
When it comes to alpha generation, the head of multi asset said the expanded universe of course generated alpha relative to the simple universe, but did so with lower volatility and maximum drawdown.
However, Mancuso’s research showed that this hasn’t been the case across market cycles. Before and during the global financial crisis, for instance, his data suggests passive simple portfolios on average returned less than their active multi-asset counterparts and did so with higher annualised volatility and maximum drawdowns.
After the crisis and in a post-QE world, however, passive simple funds have comfortably outperformed their active counterparts – albeit with a slightly greater volatility and higher drawdowns.
“Our analysis suggests that neither the value of active asset allocation nor the benefits of investing in an expanded universe are stable through time,” Mancuso explained. “In fact, our results suggest that they are cyclical.
“Since hitting a low point in 2013, the benefits associated with an expanded asset universe appear to be resurfacing. Should the normalisation of monetary policies continue, we would expect them to increase further.
“The value associated with active asset allocation appears to be highly cyclical. In short, active managers seem to have most scope to produce significant alpha during market inflection points.”
In terms of the cyclicality of asset class allocation, Architas’s Adrian Lowcock said this is the “nature of the beast”, as there are often long periods of time when certain asset classes outperform.
“Following the financial crisis it was gilts and developed market equities, prior to that commodities, emerging markets and gold had delivered for investors,” he reasoned.
“There are frequently inflection points where there is a change but they are not necessarily clearly sign posted and often only obvious in hindsight.
“An active asset allocation usually involves an investor taking money out of expensive areas and switching into less expensive markets (relatively) but timing is not easy as a market can remain expensive for a long time, but when the rotation does happen the diversified portfolio will come into its own.”
When it comes to active allocation or investing in an expanded universe relative to more traditional 60:40 constructs, he said most studies show that asset allocation, and active asset allocation in particular, is the main driver of long-term returns.
The issue, according to the investment director, is that there will always be at least one asset class which will be the best performer and will therefore shine a flattering light on any fund positioned in that space.
“Over the past 10 years the two asset classes to have been in were government debt and developed equities so the more traditional funds were in the right place by fortune more than design,” Lowcock explained.
“However, gilt yields cannot fall forever, even though they have frequently defied expectations. This is a bit like a stopped clock being right twice a day or the fact that single country emerging market funds always outperform a broader emerging markets fund but it’s never the same country from one year to the next.
Performance of index over 10yrs
Source: FE Analytics
“Asset allocation is essential to long term investment performance.”
Martin Bamford, managing director at Informed Choice, agreed that the bulk of variance between portfolios comes from asset allocation decisions as opposed to market timing and stock selection.
“We often see investors making things far more complicated than necessary,” he said. “Investing in anything other than the main asset classes of equities, fixed income and commercial property does little to reduce risk through increased diversification or improve the prospects for higher returns.
“If anything, the expanded asset class universe can mean higher costs and greater risks. Active asset allocation is more likely to result in cyclical returns, as fund managers are not guaranteed to make the right decisions.”
While he said there are no right or wrong answers regarding multi-asset investing styles, the managing director rarely uses multi-asset funds as he prefers to have control over underlying assets to manage risks.
Jason Hollands, managing director at Tilney Group, said it is important to recognise that, since the crisis, there has been a period of unprecedented monetary stimulus which has fuelled a synchronised bull market in both equities and bonds with high levels of correlation.
“Against that backdrop, it’s not surprising that simplistic equity and bond products that are exposed to full market beta through passives have performed well against genuine multi-asset funds focused on delivering risk adjusted returns through diversification. In rising markets, you’re going to be rewarded for being fully invested with minimal drag from cash or costs.
“The question is whether you think this abnormal environment is set to continue and the bull mark for both equites and bonds will just go on for ever,” he said. “It clearly isn’t as the US has already begun raising rates and the Fed is expected to begin unwinding its bloated balance sheet and the ECB [European Central Bank] is also expected to begin tapering its own asset purchase programme.
“It’s a quite dangerous environment brewing for those investors who are long bonds.”