Sophisticated made simple.
Some investors might have thought they could do no wrong in the markets last year, but just as there are no guarantees in life, there is no such thing as easy money. You can, however, stack the deck in your favour with investment “smarts,” such as a nimble asset allocation strategy – as discussed during a recent episode of Investments Unplugged with Philip Petursson, Manulife’s Chief Investment Strategist.
The historical perspective on asset allocation
The topic of asset allocation went largely unexplored until 1986,1 when Gary Brinson, Randolph Hood and Gilbert Beebower published a revolutionary study that changed the way that investors thought about it. Their study of 91 large pension funds from 1974 through 1983 found that asset allocation was the primary determinant of the variability of a portfolio’s return. Security selection and market timing played only minor roles.
The investment industry turned this study into a sales pitch, often misquoting it to say 93 per cent of a portfolio’s return is due to asset allocation. And many believed, incorrectly, that asset allocation was a one-time thing. “Set it, and forget it” became the mantra. The errors did not go unnoticed, and in 1997 William Jahnke published a report entitled “The Asset Allocation Hoax” criticizing the interpretation of the original study. Jahnke said asset allocation should be viewed as a dynamic process that takes into consideration both individual investor goals and capital market opportunities, including risk – both of which change. He asserted that the most important investment decision should not be fixed at some arbitrary point in time.
The insights of active management
Diversification is an approach aimed at reducing risk by distributing investments among various financial instruments, industries and other categories, each of which would respond differently to the same market event.2 For example, a client might sit down with an advisor and determine that the client was a balanced investor. The client’s portfolio would then be set at a traditional balanced approach of 60 percent equity and 40 percent fixed income, an allocation that might not be revisited again.
Over an extremely long period of time, that would work,” says James Robertson, Senior Portfolio Manager, Manulife Asset Management Limited. “But over medium periods of time you may go through situations where you have very massive underperformance in various asset classes.” During periods of disappointing returns, an investor is more likely to get discouraged. That’s a problem because when investors are put under stress, they may abandon their investment strategy.
“If diversification is set it, and forget it, and hope, we think of asset allocation as the Wayne Gretzky analogy; to go where the puck is going to be, as opposed to where the puck is now,” explains Robertson.
“You never want to be sitting on dead money (an investment that isn’t working),” says Alex Richard, Director, Senior Investment Analyst, Canadian Asset Allocation, Manulife. “If you can recognize asset classes that have a better opportunity, shift to them,” he adds.
An outcome-oriented approach
The Manulife Canadian Asset Allocation team has the resources, models and processes in place with over 25 investment professionals dedicating their time to this ongoing strategy. They dig deep to understand what is driving revenues and make sure they have capital in areas with the best potential returns.
“We diversify across asset classes. We diversify across asset managers who manage diversified portfolios,” explains Robertson. “We look at asset allocation as really much more outcome oriented. So … when we look out across the swath of our portfolios, for instance, we think of our growth portfolios as designed to basically generate equity-like returns while potentially reducing volatility. At the most conservative end of the spectrum, we think of our conservative portfolios as getting better than fixed income returns for similar levels of volatility.”
To do that, the team takes a two-pronged approach. They build the majority of portfolios on the best risk-adjusted returns over a five-year horizon, at the same time capitalizing on shorter-term (3- to 18-month) opportunities. The short-term allocations are designed to either add return to the portfolio or, given certain circumstances, de-risk the portfolio to some extent. “We think of asset allocation as an ongoing process by which we are constantly thinking about allocating capital to where it’s going to be treated the best,” says Robertson. “So we’re going to be taking it away from asset classes with lower expected future returns (i.e., they are expensive) and moving them towards asset classes with higher expected future returns (i.e., they are cheap).”
What is the outlook today?
At the very top of the house, we would want to be overweight in equities,” says Robertson. “On the fixed income side, we’re a firm believer in active management. So we make sure that any fixed income exposures that we have are allocated to portfolio managers who have the flexibility to navigate their way through an environment of rising interest rates.” This means they have the ability to move in and out of the credit world, shift up and down the duration spectrum and ideally even take on a currency strategy from time to time.
Within equities, Robertson describes U.S. equity valuations as “full today when you compare them against where valuations are in Europe or emerging markets, which are much more attractive to us … as long as the global synchronization persists.” With the team’s five-year expected return outlook, as a market – like the United States in this case – starts to get stretched on a valuation basis, expected returns are reduced. “You see that developing, and you start to see other asset classes look a bit more attractive. It becomes very stark, and that is what we respond to,” explains Robertson.
Asset allocation solutions
It can be hard for investors to know when to change lanes. “Over time, people always want to hold on to winners. ‘It’s going up – that’s why I want to hold on to it,’” says Petursson. But when the market keeps rising, investors can inadvertently sew their portfolios to more risk than they are truly comfortable with.
Advisors can help investors understand when to make changes to their portfolios. With the potential for more volatility in the market this year, compared with previous years, investors should be looking at the fundamentals again. During this time, investors may appreciate guidance in rebalancing their portfolios and identifying market opportunities. Learn more about Manulife Asset Allocation Portfolios at www.manulifemutualfunds.ca.