As pressure on active asset managers intensifies, experts have played down the failings of tactical asset allocation strategies to deliver results.
A study conducted by Aegon and shared with Fund Strategy shows funds that did not make market calls and cost less have performed better than more expensive funds which followed a tactical or strategic asset allocation.
Funds with a static asset allocation – which simply rebalances to keep the split between equities and low-risk assets such as bonds – delivered the highest returns over the past four years, it found.
They beat those with a tactical allocation – which adjusts daily, weekly or quarterly in response to medium- and long-term market changes – or strategic allocation – which changes annually to return to the original allocation if asset classes deviate considerably from returns.
But experts argue the unprecedented market conditions of recent years, particularly the effect of quantitative easing, have naturally favoured more passive-led strategies, making active fund managers’ job harder.
Fund Strategy asks whether we are set for a change in how we think about asset allocation.
Sticking by bonds
In its analysis, Aegon looked at returns data from Morningstar on 23 funds and five simulated static allocation portfolios after an average 0.22 per cent charge.
The firm compared average returns with those of its Balanced Plus Core Portfolio, which follows a strategic asset allocation, and 16 tactically allocated funds.
For a medium-risk fund, the analysis shows that, between 2013 and 2017, a static asset allocation delivered an average return of 11.7 per cent, outperforming 9.6 per cent for a strategic allocation and 8.2 per cent for a tactical asset allocation.
This means funds that applied a tactical allocation, which usually cost between 0.45 per cent and 0.7 per cent, have underperformed cheaper and less active funds.
Aegon investment director Nick Dixon says: “Tactical asset allocation strategies have failed to prove that they offer value for money in the positive market environment of the last four years.
“The average static asset allocation fund is low-cost to reflect the fact that investors are not paying a manager to take a more active approach.”
Tactical asset allocators have been incorrectly predicting a sell-off in the bond market for the last 10 years and have got it wrong for the last 10 years
Experts note that one of the main reasons why most active asset allocators underperformed is because they have been bearish on bonds with the belief they would fall in value.
Conversely, static funds have kept their positions in bonds while they were growing in price. They have also had a large allocation to the US equity market, which has performed strongly over the past years.
However, Hargreaves Lansdown senior analyst Laith Khalaf argues that the trend of rising interest rates may put an end to the strong showing we have seen from the bond market, and, looking forward, a heavy bond weighting looks like it might be “a millstone” that drags performance down.
However, he says for cautious investors bonds still offer diversification benefits to equity selection.
Khalaf says: “Active asset allocation is more of an art than a science and there are very few fund managers who can do it well.”
Seven Investment Management senior investment manager Peter Sleep is cautious about bond returns and expects a sell-off soon.
Sleep says: “Negative long-term bond rates almost defy belief, particularly as the world’s central banks are working feverishly to try to generate inflation by printing money and as the world’s governments have been spending furiously. But the unimaginable has happened, catching out tactical asset allocators all over the world, leaving those with a static asset allocation looking like geniuses.”
With interest rates expected to rise, Sleep is currently underweight bonds and overweight alternative investments intended to match bond-like returns with low volatility.
Sleep says: “Tactical asset allocators have been incorrectly predicting a sell-off in the bond market for the last 10 years and have got it wrong for the last 10 years. This is not to say they will always be wrong. The winding down of quantitative easing could bring a bond market sell-off closer. There is very limited upside in most bond markets, but potentially quite a large downside, so financial advisers need to be careful in this area and seek to diversify their risk with bond-like alternatives.”
Sleep also cites the recent Brexit sell-off as a challenge for pure tactical funds. He says Brexit was “the cherry” on the top of the cake for a sterling investor over the past year, causing more conservative static asset allocations to perform better on a risk-adjusted basis.
Indeed, static asset allocations generally have a high weighting to low-risk sovereign bonds in foreign currencies.
Architas investment director Adrian Lowcock defends more active fund managers, arguing that the rising value in US equities has helped passive-heavy approaches over the past few years.
He says: “Static asset allocation models have benefited in recent years from the rise in valuations of US treasuries and US equities as these portfolios only reallocate back to the original weightings so retain most of the exposure.
“But the US market will not always be the best performer and US treasuries are not going to repeat their performance as rates rise. However, the timing might still be some way off as markets have the tendency to surprise investors and will continue to rise far longer than investors expect.”
Turning strategy into success
Aegon believes that a strategic asset allocation is more suitable in turbulent market times.
To back this up, the firm recalls the period of the financial crisis of 2007, when risk-rated funds with a static asset allocation underperformed other strategies.
Dixon says advisers need to be prepared to accept the strong correlation between the fund’s return and the market’s return, and the lack of flexibility some funds have to adapt to changing market conditions.
He says: “There’s a great deal of uncertainty in the macro-economic environment at present and many people view markets as overvalued, particularly in the US, where static strategies will tend to hold a high weighting due to the US’s large market capitalisation.”
But Lowcock says there is always the risk that the strategic thinking is wrong and that a more frequent and short-term rebalancing of assets is the more “prudent” option.
There’s a great deal of uncertainty in the macro-economic environment at present and many people view markets as overvalued, particularly in the US
He says: “Tactical asset allocation works and can be seen by the difference in performance of individual fund managers in a sector.
“I don’t think there are many multi-manager funds which just look to use tactical asset allocation, instead preferring a combination of longer-term strategic asset allocation combined with shorter-term tactical decisions taking into account current events.”
Architas increased its exposure to UK property after the Brexit vote as it had been hit fairly hard during the run-up and immediately following the referendum result. It allocated to the Rathbones Global Opportunities fund, a global equity fund as opposed to multi-asset, to reduce its UK exposure, particularly to retailers, in favour of the US and Europe.
Close Brothers Asset Management uses a mixed approach to asset allocation, blending strategic positions and selected fund managers.
CBAM investment director Matthew Stanesby says: “One of the things we pay attention to is to make sure that my balanced fund stays a balanced fund.”
The firm partners with Moody’s to help create a strategic asset allocation. The balanced fund generally has 65 per cent in equities, 25 per
cent in bonds and the rest in alternatives.
Stanesby says: “Moody’s will tell us that the fund will give us a return of 5 per cent per annum and if you look at our numbers since inception we’ve generated something close to 9 per cent per annum. I’d say that is value added through a combination of asset allocation and good fund choices, but that is a very broad-brush approach.”
Stanesby argues the way the firm’s asset allocation changes is part of an “evolutionary process”, as opposed to other managers who “are quicker to make big changes”.
He says: “We know that politics is going to cause issues, but we don’t see that causing a recession. You have Brexit and Trump but these things will come out of the woodwork.
“We get these pressures but they tend to be short term. We have raised equities from 65 to 68 per cent. We are overweight US, Europe and Asia, and underweight the UK.
“The US position has changed the most, we were overweight in 2016 as valuations were creeping up, then we’ve gone underweight as we got more concerned.”