A better shot for pension portfolios

Category: Asia, Global, U.S.A.

Strategic asset allocation should be anchored in valuation, says Schroders

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Schroders argues that traditional asset allocation frameworks lead to inefficiencies, as managers do not have the scope to fully respond to changing market conditions.

Instead, Schroders advocates a conditional approach to asset allocation, under which the valuation of assets is the key factor determining their inclusion in a portfolio.

Chris Durack, chief executive officer, Hong Kong, and head of institutional business, Asia Pacific at Schroders, says: “The standard model of investing is predicated on having a long run strategic asset allocation based on assumptions about long-term returns, long-term volatility and the way asset classes are correlated with one and other over long periods of time.”

“But as we all know markets move around and what tends to drive markets, in terms of their forward returns over time, is the valuation that you buy an asset class at to begin with.”

He explains that if equities are cheap, the likelihood that you will get a better return over the subsequent three-year period is higher than when they are expensive.

“We have looked into global equity market returns over the last 40 years. Average annualised three-year return would be 17%, when entry made at 14 times price-to-earnings, compared to 3.7% when investing at price-to-earnings of 24 times or above*. There is a very strong causal effect between starting value and subsequent return,” he says.

He adds that while this approach may seem obvious, in many cases managers keep buying assets regardless of their valuation because that is what their strategy dictates, even when markets become expensive.

“Making sure you are buying assets because of their individual contribution to the overall portfolio objective is a fundamentally different way of thinking about an investment problem,” Mr. Durack says.

A key part of Schroders’ conditional asset allocation strategy is giving managers the flexibility to invest where they see value, without them being restricted by a traditional asset allocation framework, such as holding 60% equities, 40% bonds.

Mr. Durack says: “You need a more flexible approach to investing. A fixed asset allocation approach is not efficient because it is not really taking into account all of the available information that you have.”

“Our contention is that it makes sense to alter your behaviour in response to market conditions and with a fixed asset allocation strategy, you can’t do that. You want to skew the odds in your favour. More flexible portfolio designs that allow the manager to hold cash when markets are more expensive, provide the optionality to reinvest in markets when they become cheaper again,” Mr. Durack points out, adding that he thinks Schroders’ conditional asset allocation strategy is particularly suited to pension investors, as they need to earn a real rate of return over a fixed period of time, and this cannot always be achieved through a fixed asset allocation strategy.

Research carried out by Schroders found that while a traditional 60%/40% balanced portfolio has tended to earn an annual real rate of return of around 4-5% over the long-term, the rate earned by an individual investor is actually very dependent on the period of time in which they invested.

Mr. Durack contends that in the current investment environment, where return expectations are lower, investors need to take advantage of the variations in asset class returns by buying those asset classes when they are cheaper than their long run average.

“If you think about it as being a distribution of outcomes through time, buying at the cheaper end of the distribution will give you a bit of a tail wind. If you apply that technique across a wide range of asset classes you give yourself more opportunities to find where that good value is,” he says.

Mr. Durack continues: “For someone who is saving for their retirement, the benefit of applying that approach is to achieve hopefully more consistency around the core investment objective they have, rather than lose confidence in the highly volatile outcomes and have a funding shortfall when it comes to retirement.”

The group’s objective-based strategy has been popular with both institutional and retail investors in the UK and Australia and it is starting to gain traction in Hong Kong and the rest of Asia.

“If you look at the pattern of demographics and the importance of focusing on what people are really trying to achieve and how much time have they got, this is the strategy to consider,” says. Mr. Durack.

“We think given the current environment there is going to be more focus on asking fund managers to invest in this way,” he concludes.      

Important Information

This document is intended to be for information purposes only and does not constitute any solicitation and offering of investment products. Investment involves risks. This material has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.

Schroder Investment Management (Hong Kong) Limited
Level 33, Two Pacific Place, 88 Queensway, Hong Kong

Telephone +852 2521 1633 Fax +852 2524 7225            *Source: GFD, 31 Jan 1970 to 30 Sep 2014 in USD.