After what has been a very long run of strong market returns, it is only natural that investors’ attention starts to move toward when that run might end, and as each day passes, we move closer to the end of the cycle. This kind of sentiment understandably makes investors somewhat nervous when deploying capital, particularly at a time when market volatility has picked up after a prolonged period of calm.
While it is obviously prudent to pay close attention to market conditions prior to making an investment, it is unwise to let emotion rule the decision. Numerous behavioural finance books and studies on market timing tell us that the practice is likely to lead to a sub-optimal result and that it is very difficult to pick market inflection points. When constructing a long-term portfolio today the three main considerations should be:
- the return objective,
- the risk tolerance (and investment time horizon), and
- the level of portfolio liquidity required.
These are the key factors that will help determine the appropriate (long-term) strategic asset allocation, with current (short-term) tactical views then dictating the final portfolio weights. By thinking in this way when establishing an appropriate strategic asset allocation we can help minimise the pitfalls of human behavioural tendencies that may cloud investors’ judgement.
Alternatives are key to true diversification
In a world where investment opportunities are increasingly global in nature, it makes sense to build truly diversified portfolios. Investors should consider taking advantage of opportunities not available in domestic markets while also benefiting from the ability to diversify risk, as a function of imperfect correlations between regions, as well as across asset classes.
Building fully diversified portfolios can help investors generate higher risk-adjusted returns, smoothing volatility through time while also achieving long-term return objectives.
Alternative assets, which are expected to be uncorrelated with traditional asset classes, such as equities and bonds, are increasingly becoming an important allocation for Crestone’s clients. This is reflected in current strategic asset allocation weights, where alternatives make up between 16% and 20% of diversified portfolios.
A high single-digit return requirement, combined with a five-year investment time horizon, is a common situation. When combined with an understanding of an investor’s risk tolerance, we can use forward-looking assumptions of risk, return and correlation to construct portfolios, which are expected to maximise return for a given level of risk.
Expect subdued returns
In the current environment, asset class return expectations are subdued relative to the recent past, which is a function of both low interest rates and high asset valuations. As a result, we have seen our major research partners adjust return expectations lower to around 6.5% p.a. for equities and 3.5% p.a. for diversified fixed income. Under these assumptions, generating high single-digit returns, which could have been achieved by a portfolio dominated by defensive assets over the last five years, is now challenging – even if we skew heavily towards risk assets such as equities.
The chart below shows the benchmark performance of three of Crestone’s strategic asset allocations over the last five calendar years, all of which have benefited from strong performance across all major asset classes. In fact, as noted above, the yield portfolio, which has more than 60% allocated to fixed income and cash, achieved our ’high single-digit’ return target (7.5% p.a.), while a growth investor would have seen stellar benchmark returns of close to 12% p.a.
With a more challenging return environment for major asset classes, investors must either accept a lower return expectation or increase risk in order to reach their return objectives.
With careful management of tactical exposures, and by implementing investment strategies that can outperform their benchmarks (upon which the above assumptions are based), we believe that investors will still be able to generate meaningful returns and meet their objectives, whilst maintaining prudent risk tolerances. For this reason, we recommend our clients hold globally diversified portfolios while seeking out best-in-class active management at the asset class level and closely monitoring tactical tilts at the portfolio level.
Our tactical positioning today
Crestone’s current tactical positioning sees an overweight to cash, an underweight to fixed income, a modest underweight to equities and an overweight to alternative assets.
As always, later-cycle investing demands caution. This means not being overweight risk but still engaged with it. Allocations to risk assets should be close to neutral (or normal), not aggressively overweight. They should also be focused on regions and sectors where growth is strong or valuations more compelling. This involves understanding returns are likely to be more moderate and more volatile than earlier in the cycle and keeping a weather-eye on the macro-economic signals for when the growth cycle is truly shunting meaningfully weaker. Protecting capital through maturing cycles is also key.
Alternative assets are Crestone’s favoured investment at this stage in the cycle.
Seeking out high-quality uncorrelated alternative assets (such as hedge funds) that can protect capital when forecasts are wrong is paramount. When the economic cycle turns, the market’s ability to look through many of the geo-political risks that now confront us will undoubtedly be challenged.
This should also be the point investors gather comfort from a diversified portfolio and can put to work liquidity into accumulating high-quality assets at attractive prices.
Written by Rob Holder, CFA. Asset Allocation and Portfolio Analyst.
Crestone Wealth Management provides wealth advice and portfolio management services to high-net-worth clients and family offices, not-for-profit organisations and financial institutions. Find out more.