The magic ingredient: diversification
09 August 2017 | Portfolio construction
Commentary by Alexis Gray, economist, Vanguard Europe.Many investors are tempted by tactical asset allocation – the practice of shifting a portfolio's weighting as the outlook chops and changes.
Here's a question: What will happen when the central bank responsible for a major reserve currency pushes up interest rates? Do you expect the value of long-dated bonds to rise or fall?
Another one: A new president is elected to lead a large Western superpower, promising to cut taxes and increase public spending. Your investment adviser calls, highly excited, urging you to invest in that country's equities. More money flowing through the system will be good for business, she reasons, and will increase economic activity, pushing the equity market to rally.
One more. In a mid-size island economy off the coast of Western Europe, growth is at the high end of expectations, employment is solid and inflation is rising. How do you expect the central bank to react? As an investor, do you buy bonds or equities?
Unforeseen, unexpected, inexplicable
Despite my extremely careful anonymisation, it might be that you recognise one or two of the scenarios described above, all of which are indeed based on true stories. What makes them interesting, or one of the things that makes them interesting, is that they represent events which were either unforeseen or in which investors reacted in unexpected, even inexplicable ways.
The United States Federal Reserve started raising interest rates in December 2015. It raised again in December 2016 and again in March and June 2017. The value on long-dated bonds fell, but not by much. Why not? Several reasons seem to apply. One is that investors continue to believe that rate rises will be slow and shallow and that cash flows, coupon payments and redemptions will keep pace. Another is that institutional investors are moving back into higher-quality, long-dated bonds as yields rise, as they were never really comfortable chasing yield in lower-rated credit bands. A third is that substantial numbers of investors don't yet believe that the Fed will follow through.
Our second example: Trumponomics. Your adviser probably told you to hold off during the election and may well have thought that a Donald Trump victory would send the equity market reeling. An inexperienced president with few clearly deliverable policies was seen as a huge risk. It was only after he won that investors started to think about the flow of those dollars. For a sterling investor, according to Bloomberg, the return on US equities from 8 November 2016 to 30 June 2017 was 11.3%.
Tactical asset allocation makes superb conversation: What's hot? What's coming off the boil? Which way does trouble lie? What's your view? We see a trend. The underlying data tell a different story. How are you positioning the portfolio? We've gone overweight. And so on. And so on.
Asset classes have definite, even predictable characteristics that play out over the medium to longer term. But foretelling the behaviour of an asset type in the shorter term is devilishly complex. Once the conditions affecting the asset emerge, they are immediately priced in. A tactical investor then needs to work out whether other investors will adjust or change their views, or whether other events, entirely unexpected, are likely to disrupt the market altogether.
If the timing is right the investor will benefit, at least for the time being, but at the cost of deviating from the risk exposure implied by the strategic asset allocation. If the timing is wrong, or if fresh events interfere, the drawdowns, or short-term losses, can be large and hard to make up.
Let the market work for you
For most of us, most of the time, rather than trying to beat the market, we are better off letting the market do our work for us. The simple way to get the market onside is through a regularly re-balanced, well-diversified portfolio with assets allocated strategically.
In the example in the accompanying chart, we have used the Vanguard LifeStrategy 60% Equity Fund (dark red line) as a proxy for the market. This is an all-passive portfolio but we should not be distracted by its composition. It can consist of either active or passive investments, in almost any proportion, so long as the risk-return payoff of the portfolio as a whole is focused on the specified goals of the individual investor.
Note: Past performance is not a guide to future returns.
The lesson to draw from the chart is the value of balance, diversification and a strategic approach. Investors may miss the peaks of rallies in particular markets, but they will also avoid the depths of corrections and drawdowns. In the chart, the returns of the LifeStrategy 60% Equity Fund remain reasonably steady regardless of what is going on the world. (Of course, past performance is not a reliable indicator of future results).
As interesting as it is to talk about the prospects of different asset classes in relation to current conditions, evidence shows that most active managers who use tactical asset allocation struggle of producing consistent, durable, positive excess returns after fees. Where the evidence does point, and very clearly, is to the importance of a well-diversified strategic asset allocation, implemented in a cost-effective manner and maintained over time.
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