Strategic asset allocation in a post-pandemic world
In this article, I would like to highlight the areas that investors should focus on when considering their long-term investment plans1; suggest a few solutions, taking into account different risk and return expectations; and, lastly, propose a cost-effective solution for implementing this kind of strategy.
While debates about the long-term impact of the COVID-19 pandemic are likely to persist for some time, there are important elements that investors can already consider today: diversified, active, and forward-looking asset allocation will be more important in the future than it has been in the past. The reasons for this are the unprecedented measures that have been put in place worldwide to fight the virus, their potential impact on asset returns, and the likely changing nature of cross-asset correlations.
Over the past 20 years, a typical diversified portfolio consisting of 60% equities and 40% bonds delivered high riskadjusted returns. This was due primarily to two factors. First, equity and bond markets enjoyed negative correlations, which means that any negative return on equities was compensated for by positive returns on bonds and vice versa. Second, interest rates were positive and relatively high in a historical context. At the beginning of the century, ten-year German Bunds were yielding 5%, while US Treasuries of similar maturity were yielding 6%. As interest rates continued to fall, price appreciation allowed for high returns. However, this strategy may not be appropriate in the future since the cushion provided by high interest rates on bonds is no longer available.
In the current low/negative yield environment, it is also easy to foresee that this negative correlation may end sooner rather than later. While there are structural forces at play that have brought interest rates lower since the early 1980s (e.g. globalization, tight monetary policies, demographics), there are convincing signs that make me believe the latest policies put in place by governments and central banks throughout the world are sowing the seeds for higher interest rates in the future. Fiscal expansion monetized by central banks is becoming the norm in major economies, while monetary policies will tolerate higher inflation in the future to compensate for lower inflation in the past. And, if the past is any indication, major central banks are likely to follow in the footsteps of the US Federal Reserve Bank.
On the back of growing populism and the US–China trade war, globalization has also stalled in recent years. Many governments and some companies around the world are looking at re-shoring production capacities domestically, partly for political reasons, partly for security reasons. The pandemic is actually accelerating this phenomenon. Rather than creating those shifts, COVID-19 has in fact accelerated trends that were already in place before the pandemic unfolded. So, if you believe that globalization and tight monetary policies helped to further reduce inflation, de-globalization and lax monetary policies are likely to do the exact opposite.
Whether such a scenario materializes in this decade or the next, investors can and should already start positioning their portfolios accordingly. Bond markets cannot provide the same degree of diversification as they have in the past given the fact that they are now providing low or negative yields. Moreover, the negative correlation between bond and equity markets is likely to turn positive again, as was the case for most of the twentieth century. The historical diversification benefits enjoyed over the past 20 to 30 years can no longer be expected to hold true for the next 10 to 20.
So, what does this mean for investors?
First, investors need to consider a broader set of assets in order to increase their return expectations and diversification benefits. To illustrate this, we have built three portfolios with a five-year time horizon for Europe-based investors with different risk and return considerations. The bond allocation (nominal assets) is hedged into euros as the FX volatility is proportionally high compared to the underlying asset. Equities (real assets) are left unhedged as they provide real returns over time, so the FX component is close to zero over the long run.
The results can be seen in Chart 1 and Table 1. To achieve returns of 2% p.a. in euro, an investor needs to factor in a volatility of around 5%. As a matter of comparison, cash – a risk-free asset – is currently yielding –0.5%. This means that, in order to achieve additional returns of 2.5% p.a., Investor A can expect the range of returns to be between –13% and +17%2 p.a. This kind of portfolio is still considered relatively safe, with 75% of the portfolio allocated to fixed income and 25% to equities and alternatives (e.g. private equity, hedge funds).
Investor C, who is ready to take on more risk, can expect a return of 3.5% p.a. with a volatility of 10%. This means that his range of returns is expected to be between –26.5% and 33.5%2. The portfolio composition would be materially different, though, with low exposure to government bonds and high exposure to equities, real estate, and alternative assets. While this analysis provides suitable guidance for a large set of scenarios, results will obviously be significantly different should extreme events occur.
This leads me to my second key point, namely that active management is required to respond to material shifts in the economy and the world. We are living in unprecedented times and are standing at a crossroads where very different outcomes may unfold. In this context, a static portfolio is not appropriate.
Third, a higher allocation to assets that provide diversification to extreme events is required because the tails of the distribution are getting longer. In other words, the need to account for a higher likelihood of extreme scenarios is more important now than it was in the past. Here, the key is to think gold and digital assets: the former as a hedge against extreme geopolitical events and an exploding money supply on the back of fiscal and monetary largess, the latter for the same reasons, but for younger generations as they tend to have more affinity to digital assets than precious metals.
Asset allocation at different risk and return expectations, five-year investment horizon, in euro
|Asset class||Investor A
|Corporates high quality||20.0%||15.0%||5.0%|
|Corporates high yield||5.0%||5.0%||5.0%|
|Corporates emerging markets||5.0%||7.5%||10.0%|
|Private debt & loans||2.5%||5.0%|
|Total nominal assets||75.0%||57.5%||40.0%|
|Developed market equities||10.0%||20.0%||30.0%|
|Emerging market equities||5.0%||7.5%||10.0%|
|Private equity & infrastructure||2.5%||5.0%|
|Total real assets||25.0%||42.5%||60.0%|
This is an indicative asset allocation that may change over time.
The target return is no projection, prediction or guarantee of future performance and there is no certainty that the target return will be reached.
The fourth main point is implementation. Many good ideas result in poor outcomes because of poor execution. At Credit Suisse Asset Management, the fourth-largest index and ETF provider in Europe with AuM totaling more than CHF 130 bn, we believe that index products should be used predominately for allocation to core markets, while active funds should be deployed for niche segments such as thematic equities, emerging markets, Chinese corporates and equities, or private debt and loans, to name a few. This so-called “core-satellite” approach has two major advantages:
- It allows for a high degree of diversification by investing in the entire market, thereby avoiding unsystematic risk.
- It provides a cost-effective investment vehicle with low TER3 to core markets where active managers have difficulty delivering outperformance over time. These cost savings can then be deployed to satellite markets that are typically less mature and efficient and where active managers have a higher chance of delivering outperformance over the long run.
As mentioned above, I truly believe we are living in unprecedented times. On the economic front, governments and central banks have been implementing additional stimulus with each new crisis. While the justification of such policies is beyond the scope of this article, they materially affect volatility, return expectations, and cross-asset correlations, which in turn impacts how a portfolio should be positioned. On the geopolitical front, we are witnessing the rise of a giant – China – which is challenging the status quo by being more assertive. This conflict of opinions between the established power – the US – and the rising challenger is creating uncertainty and increased volatility as well as opportunities. More than ever, in such an environment, active management and portfolio agility are required to maximize the chances of avoiding pitfalls and capturing opportunities created by a fast-changing world.