Strategic asset allocation has been considered a driving force behind investment portfolio returns for a long time. But the old saying that 90% of performance is decided by project is quickly becoming outdated.
Over the course of 2020, we have now seen the world of investing transform from one where falling rates of interest boost beta performance to at least one with increasing dispersion of returns inside asset classes, regions and sectors. This dispersion is being amplified by retail investors who’ve greater access to markets through supposedly free investment platforms.
In a time of near-zero or rising rates of interest, beta will play a subordinate role in generating performance in the long run. Since the start of 2020, three phenomena have been driving the long run of investing and pushing towards more precision-oriented strategies:
1. The price mechanism
The combination of near-zero rates of interest, fiscal and monetary stimulus, and increased market access for retail investors has modified the pricing mechanism. Over the past yr, whether it was GameStop or AMC Theaters, price discovery often appeared to have been thrown out the window. Excess liquidity and behavioral “bigger fool” expectations have led investors to consider they’ll quickly sell at the next price. Leverage in public markets has increased: Whereas retail investors used to only trade stocks, they at the moment are in a position to sell their shares due to falling transaction costs for derivatives. many now act as marginal buyers via options.
Over the past yr, pension funds, sovereign wealth funds and other institutional investors with long-term investment horizons have often acted procyclically somewhat than acting as buyers of last resort during a market downturn. For example, large pension funds unhedged tail-risk hedges just weeks before the bear market began, and a few needed to sell assets in the midst of the correction to fulfill their sponsors’ unexpected liquidity needs.
The removal of this “rational investor” pricing mechanism makes it way more difficult to set return expectations for various asset classes. There is uncertainty in regards to the validity of pricing. To make matters worse, valuations of seemingly similar firms diverge more: consider, for instance, Volkswagen’s March run-up, which took into consideration the “electric vehicle premium”.
As beta has turn out to be increasingly uncertain, expectations about risk measures and correlations have also increased. This in turn reduces the usefulness of classic beta-oriented strategies.
2. Private assets
The increasing importance of returns on private assets makes it tougher to find out portfolio risks and returns using traditional methods.
Over the past decade, institutional investors have rapidly expanded their investments in illiquid and non-public private markets in real estate, private equity, private debt and direct lending. There are several reasons for this, a few of that are more compelling than others: for instance, it is sensible to expand investment offerings and diversify income streams. However, the valuation lag and supposed risk reduction advantages of non-market-priced assets hardly seem logical. Particularly in classic strategic allocation studies, such biases result in naive private investments that ignore adequate diversification inside the asset class.
Why else do investors look to non-public markets? Because they provide targeted investment opportunities that can not be found on listed exchanges. In particular, potentially disruptive developments within the industry are sometimes difficult to capture via the medium-sized and huge firms on the general public markets.
Thanks to greater computing power, knowledge distribution, and outsourcing opportunities, developing novel products in industrial automation, oncology, behavioral stimulation software, and other areas has turn out to be much easier, provided you may have access to the correct mental and enterprise capital.
The potential of those sectors will remain for a very long time to come back. But only when their technological developments turn out to be viable for investment on a big scale will they divide into winners and losers, while concurrently giving a lift to all the sector. In the pharmaceutical sector, for instance, lots of essentially the most profitable innovations of the previous few a long time have been developed locally in life science parks. Investing in, for instance, the ten largest pharmaceutical firms wouldn’t have been targeted enough to learn from these developments.
Whether it’s antiviral treatments or gene therapies, precise – and dangerous – investments in firms in sectors ripe for disruption are more lucrative than moving up the chance spectrum of public markets. However, strategic asset allocation often comes with limitations. It may be difficult or unattainable to pick out area of interest managers with deep ties to the sector in query. In general, these targeted investment strategies don’t fit into top-down investment guidelines and are subsequently discarded. As a result, large institutional investors leave the return opportunities to smaller players akin to entrepreneurial family offices.
For investors, the broader range of opportunities should outweigh the potential downsides, even when the overly positive biases within the investment process are tempered. Careful bottom-up portfolio construction techniques should offset concentration risks, and reasonable risk and return expectations could possibly be incorporated into allocation decisions. Or higher yet, private and non-private equity investments could possibly be combined right into a single portfolio construction to enhance diversification.
3. Regime change all over the place
Developments over the past yr have accelerated the pace of transformation within the industry. The development of an extended list of performance drivers now makes it much more vital to review risks on a dynamic and individual investment basis.
Longer-term trends coupled with the measures taken to counter the impact of COVID-19 on the worldwide economy have only magnified the effect. Changes in the best way people work – offices vs. distant, physical vs. digital, and native vs. global – are influencing near-term perceptions of investments. What will occur to office buildings? How many achievement centers shall be needed? How much is a restaurant chain value that may only deliver to homes? In the long term, the winners will differ from the losers, with some industries emerging more resilient than others.
Governments all over the world have responded to the crisis in other ways, but most have used the identical toolbox, looking for stabilization and compensation through debt issuance. Even if the resulting debt levels are deemed everlasting, policies will eventually have to be normalized to avoid a way more centrally planned economy than pre-Covid.
At this point, dispersion inside asset classes will increase again. Which regions, sectors and corporations have taken simpler steps over the long run to forestall capital destruction when pandemic-related fiscal support measures are withdrawn?
Another factor driving market diversification? The increased concentrate on environmental, social and governance (ESG) aspects. Governments have considered various “Green New Deals” that may provide financing opportunities to “green” firms or projects. Central banks, the IMF and the World Bank have followed an identical focus. From a macroeconomic perspective, the direction of laws is becoming clearer; some investments shall be higher positioned than others.
The geopolitical situation is one other factor. Increased competition and deglobalization efforts to create more robust supply chains, whether for semiconductors or the production of agricultural staples, could lead on to increased tensions. A rupture in global relations could bring each risks and opportunities. The Asian tigers could worsen their situation, while things could improve in Latin America and India. These growing long-term uncertainties make it particularly difficult to ascertain a sound strategic asset allocation process and stick with it over the subsequent decade.
The evolving environment and accelerated pace of change require a deeper understanding of monetary and behavioral dynamics, geopolitics and underlying investments. Without a more holistic and practical approach, investors will miss out on returns while risking more by involuntarily accepting economic concentration risk.
What’s next?
Achieving optimal returns on this recent era requires investment governance that delivers detailed, timely investment decisions. This means a more integrated investment framework and recent and different methods of assessing risk.
Clinging to the established order only comes on the expense of performance.
If you liked this post, don’t forget to subscribe.
Photo credit: ©Getty Images / chaluk
