Multi asset investing The importance of staying active

Equities historically have produced superior returns over the long term¹. Over shorter periods, however, equity returns can fluctuate significantly.

Fig. 1 shows that if one held US equities for only one year between 1900 and 2018, the returns varied between -61% to 133% – a very volatile range triggered by investor sentiment and market events. If the holding period was extended to 10 years, then the range narrowed to -5% and 21% per annum (p.a.). With longer holding periods, volatility decreased and returns stabilised in the positive range.

Fig 1: US equities annualised total returns (%), 1900 - 2018²

Given the significant performance divergence in shorter holding periods, for investors who may not have the luxury of extended holding periods, how can they achieve good stable returns?

A multi asset portfolio seeks to deliver steadier returns even for shorter holding periods. By including defensive assets, drawdowns can be lowered during market downturns, such as holding government bonds during the 2008 global financial crisis.

Fig.2 shows that a portfolio with a static allocation of 60% global equities and 40% global bonds would have registered a much lower volatility of 9.60%, as compared to 14.26% for global equites, over the past 15 years.

Fig 2: Performance of a 60/40 global equity-bond portfolio, rebalanced quarterly to maintain the allocation³

The lower drawdowns, however, came with lower returns. The 60/40 global equity-bond portfolio delivered a total return of 7.08% p.a., lower than the 8.74% annualised return of the global equity portfolio.

Nevertheless, the 60/40 portfolio still delivered a higher return per unit of risk. The diversified portfolio had a Sharpe ratio of 0.63, versus 0.57 of the MSCI World index⁴.

To enhance returns further, exposures can be ‘actively’ adjusted across asset classes instead of sticking to a static allocation as in Fig. 2.

Similar to how a cyclist uses a low gear when riding uphill, an active multi asset manager typically invests in more defensive assets during a recession (see Fig.3). A middle gear is selected on undulating terrain with a mix of defensive and riskier assets, depending on market conditions and risk profiles. A high gear is selected for high speeds on flat terrain, with more capital invested in riskier assets, such as equities, which tend to outperform during economic expansions.

Fig 3: All-weather asset allocation to cruise through economic cycles⁵

As illustrated above, a multi asset strategy allows investors to stay invested and enjoy superior risk-adjusted returns, as the manager actively allocates to different asset classes amid different economic cycles. Studies show that active asset allocation is a key contributor to performance success in multi asset portfolios⁶.

Even within the same asset class, different markets and sectors can perform differently. This can be seen from the divergent performance of US small caps and emerging market equities year to date.

High current account deficits, hyperinflation in Turkey, and a stronger US dollar have triggered sell-offs across emerging markets equities this year, as seen in Fig.4.

In contrast, US small-cap equities – benefiting from tax cuts and deregulations – have rallied 11.51% year to date⁷.

Fig 4: Performance of US small-cap equities and emerging markets equities year-to-date⁷

How long will this divergence last? What triggers will create the next set of leaders and laggards?

By observing market conditions with logic, and conducting in-depth analysis on valuation, sentiment and macro factors, experienced active multi asset managers can add value to investors.

Different reactions and utility functions of market participants also make financial markets inefficient, creating a wealth of opportunities for active managers to exploit. By identifying sectors and markets that are likely to outperform, and avoiding exposures to underperforming ones, a multi asset strategy can boost risk-adjusted returns.

Multi asset managers also have more tools at their disposal and can execute their strategies using delegated mandates, funds, exchange-traded funds (ETFs) and derivatives.

As quantitative easing gets withdrawn, causing global liquidity declines, market dispersion is likely to rise. Against such a backdrop, investors can look to a multi asset strategy to help buffer against potential market dislocations while capturing new investment opportunities that emerge.