The Most Important Factor Driving Absolute Returns
The upheaval of recent years in the financial markets and subsequent policy measures have brought interest rates to levels that would have been almost unimaginable until recently. It is high time to revise investment strategies for mandates and advisory portfolios. In the future, strategic allocations will be reviewed on an annual basis. After all, investment strategy is the most important factor driving a portfolio's absolute returns.
It has been several years since we last revised our investment strategies, when we focused primarily on harmo-nizing our mandates and advisory portfolios. In the meantime there has been a dramatic change in the financial markets. Interest rates are at record low levels, and our clients have every reason to wonder whether, given the current market environment, the chosen strategies will allow them to achieve the yields they originally envi-sioned.
Bonds Are Generating Only Minimal Returns
Based on our expectations of the capital markets for the next five years, we are anticipating that high-quality government and corporate bonds will generate low and in some cases even negative returns. Accordingly, we have reduced our strategic engagement in these asset classes. We are turning instead to high-yield bonds and bonds from emerging markets, which leads to greater diversification.
When the benchmarks were last revised, we decided to avoid currency risks on the fixed-income side. This was motivated by our conviction that compensation for such risks was inadequate. That conviction has informed our most recent review, and we have therefore included only fully hedged high-yield bonds and bonds from emerging markets in our benchmark.
Addressing Foreign Currency Risks
We have also taken foreign exchange risks into account in defining the benchmark. The turmoil in the foreign exchange markets at the beginning of the year, triggered by the decision by the Swiss National Bank (SNB) to discontinue the minimum exchange rate for the Swiss franc against the euro, has clearly demonstrated the danger posed by currency risks. The idea that the SNB would assume responsibility for currency hedging for an indefinite period has proved to be mistaken.
From the client's perspective, currency risks are a significant component of overall risk. At the strategic level, there is little empirical evidence that investors are receiving a systematic risk premium as compensation for hold-ing currencies. It should be noted, however, that currencies can offer a portfolio the benefit of diversification because they are only minimally or even negatively correlated with certain asset classes. The US dollar, for ex-ample, is often negatively correlated with the price of gold.
In the case of fixed-income investments, very little strategic compensation is provided for foreign exchange risks, so it is wise to avoid or hedge against such risks. The situation is somewhat different for equities and cer-tain alternative investments, where currencies often serve the purpose of diversification rather than acting as a risk factor. If, for example, a CHF-based investor in commodities had hedged against the US dollar over the past ten years, this would have increased volatility by roughly 16 percent.
Somewhat Greater Equity Holdings
While equities are not exactly inexpensive, following a five-year rally, they are considerably more attractive than bonds. Moreover, the returns on bonds are likely to remain low for some time, not least because of monetary easing. Both of these factors argue in favor of placing more emphasis on equities. Returns on equities from emerging markets can be expected to be similar to those from industrialized countries. Since they offer diversification benefits, however, they should be included in a portfolio, at least within the scope of their market capitalization. While that market capitalization represents roughly ten percent of the global equity market, these equities are substantially underrepresented in most clients' portfolios.
Gold as Part of the Commodity Share
With the Federal Reserve very likely to start raising prime rates this year, we may see the beginning of a new era for gold. Accordingly, we are reducing the role of gold in our strategy and will be taking a tactical approach to the management of gold. Strategically, we will continue to invest in gold, albeit to a much lesser extent, since gold is now included as part of our general commodities holdings.
We will continue to keep commodities as part of our strategic asset allocation because of their contribution to diversification. Over the long term, we expect returns on commodities to become positive again, since the de-mand for commodities and other resources is likely to continue to grow along with the global population and the standard of living. Furthermore, commodities seem to be substantially undervalued at current prices, particularly in the energy sector. This creates incentives for increased demand and lower production. Within the next five years, this should also be reflected in expected yields.
More Frequent Reviews Needed
All of the changes described above were introduced at the beginning of this year, for mandates as well as advisory portfolios. Defining the investment strategy is a crucial element in the investment process, since strategy is the most important factor driving a portfolio's absolute returns.
Although in the past strategic allocations remained unchanged for five years or more, much more frequent re-views will be necessary in the future. Recurrent upheaval in the capital markets, increased market volatility, and massive interventions by the central banks since the outbreak of the financial crisis have created a need for more frequent and fundamental adjustments of market assessments. We have therefore decided to review our benchmarks every year and adjust them as necessary.
The Importance of Strategic Asset Allocation
Numerous academic studies have demonstrated the importance of strategic asset allocation. As early as 1986, Brinson, Hood, and Beebower published an oft-cited article showing that this factor is responsible for 90 percent of variation in yields. A study by Ibbotson and Kaplan in 2000 sought to determine what share of total returns can be accounted for by strategic asset allocation. The study assumed that the average yields of all investors correspond to the market yield, as Nobel Laureate William Sharpe has demonstrated. It found that for the five percent of the best active portfolio managers, active management is responsible for 14 to 18 percent of total returns, while investment strategy still accounts for 82 to 86 percent. In other words, while active asset manage-ment can indeed generate added value, strategic asset allocation continues to be the most important factor.
What This Means for Clients
Clients need to think about the strategic weighting of the various asset classes in their portfolios and consider their investment goals. What long-term returns do they hope to achieve? What risks are they prepared to accept? And is their current strategy designed with these considerations in mind? After these questions have been an-swered, they can choose an investment strategy designed to achieve their goals at the lowest possible level of risk, taking full advantage of the potential for diversification (see box).
We often find that the allocations in clients' portfolios are concentrated in certain asset classes. For example, individual equities, often limited to the respective home market, may be disproportionately represented. Or the portfolio fails even to come close to taking advantage of the full spectrum of asset classes, instead consisting only of equities and cash reserves, for instance. Both of these examples show extremely limited diversification and a correspondingly high level of risk concentration.
Structured Investment Process
Despite the importance of a long-term investment strategy, it is common to spend too little time defining that strategy. An interesting empirical study conducted by Northern Trust in 2012 showed that even institutional investors spend more time choosing the right portfolio manager than formulating their investment strategy.
The discussion of performance is a similar case: While there is a great deal of talk about the role of tactical in-vestment decisions in determining returns, people rarely address the importance of choosing the "right" invest-ment strategy. And they spend more time discussing the selection of individual stocks than their investment strategy. The first step in the investment process – investment strategy – is often simply taken for granted, and the question is how well you have fared against this benchmark. Particularly for private investors, however, it may be more important to determine whether they have positioned themselves appropriately over the long term – by selecting the right investment strategy – and whether they have chosen a strategy that enables them to achieve their goals without exposing themselves to excessive risk. We, as asset managers, need to offer our cli-ents better support in this process, but we also need to make them aware of the added value that such support provides.
What Is Strategic Asset Allocation?
Strategic asset allocation (SAA) is the first step in the investment process. It involves defining the asset catego-ries and subcategories (for example high-yield bonds or equities from emerging markets) for investment and determining the appropriate proportions of each to achieve certain objectives (usually specific returns) without exceeding the investor's risk budget or personal risk tolerance.
Designing the optimal investment strategy requires taking into account the client's financial situation, including, for example, liquidity requirements and time frame. Individual risk tolerance is another important factor. In general, investors can expect higher long-term returns if they are willing to assume greater risk by choosing more risky investments (such as equities or high-yield bonds).
Certain risks can be avoided if the portfolio includes investments that are only minimally correlated and will not respond in the same manner to different market phases. The simplest examples would be equities and bonds: In the crisis year 2008, for instance, global equities lost 45 percent of their value, while the value of Swiss govern-ment bonds increased by 9 percent.