Financial crisis catalyst for change in asset allocation

The economic and market challenges generated by the financial crisis and its aftermath have had a profound impact on portfolio construction and are forcing investors to take a fresh look at strategic asset allocation, says Jamie Lewin, CIO at BNY Mellon Asset Management International.

Modern portfolio theory, which aims to maximise risk-adjusted returns by constructing an “efficient frontier” of optimal portfolios of assets, has proved completely inadequate during the crisis. The typical asset allocation model was simply about “ladling in exposure to growth-oriented assets in the belief that they were not adding a significant amount of risk,” says Mr Lewin.

But correlation among assets was already very high before it increased to one during the financial crisis, he explains. When growth expectations collapsed, investors’ wealth suffered as a consequence.

“Investors need to stop thinking about assets as individual building blocks and move to an approach more akin to a risk-based approach to investing,” says Mr Lewin.

A key step to build a truly diversified portfolio is to define risk buckets for all asset classes. These can be categorised in growth, inflation and deflation assets (see table).

A NEW WAY OF THINKING

“Typically, asset allocators have thought about the investment world in terms of equity, fixed income and alternatives. They have built portfolios mixing those three asset classes and increased exposure, particularly in the alternative space during the last couple of decades,” he explains.

What they failed to consider is the underlying risk characteristics of those assets, whether they were growth-oriented, inflation-driven assets, or the deflationary type.

“The typical asset allocation model has so much in growth-oriented assets, a little bit in deflationary assets and very little in inflation-driven assets. But inflation is a major shadow being cast over investors’ portfolios. Today, there are unambiguously leading indicators of a future inflation problem building in the global economy.”

There is still a huge wall of liquidity out there and central banks will not necessarily withdraw that quickly enough to abate any kind of inflation problem associated with the massive liquidity injection of the last three to five years, he believes.

A second source of inflation is result of globalisation, which is shifting the balance of power from advanced to developing economies. Rising local costs in developing economies is now a source of imported inflation for advanced economies.

Looking towards Asia, Mr Lewin predicts supply side shocks, where suppliers will not be able to keep pace with demand over the medium term for energy-based products, raw materials or food. “These three independent sources of inflation aren’t priced into markets today but represent severe long-term risks to investors’ ongoing wealth creation or real wealth preservation objective. Unexpected inflation is one of the biggest killers of wealth historically,” he notes.

Some asset classes provide very sound hedges against those inflation surprises. These include thematic equities, such as resource and infrastructure equity, real estate, commodities and inflation-linked bonds. Apart from the latter, they are all reasonable value for protecting portfolios against inflation today.

“Investors should seriously consider thinking about embedding inflation insurance into portfolios, as it looks pretty cheap to us. This can be done in a very cost-effective way, without giving up liquidity, or increasing the volatility of the portfolio or driving down return expectations, beyond transaction costs,” says Mr Lewin.

GLOBAL VIEW

The search for international diversification is becoming an acute problem, particularly in continental Europe, he says, as investors are sitting on a large amount of domestically-issued bonds and domestic equities. “That home bias is slowly but surely been eroded, with investors truly embracing global approaches to investing.”

One of the most likely outcomes is increased exposure to emerging markets. This is likely to go up to 20-30 per cent of the overall portfolio for any long-term investor over the next decade, he predicts. But rather than through individual securities or a market cap weighting, benchmark-oriented approach, the best way to gain exposure is through investment themes such as infrastructure, consumption and manufacturing, he predicts.

A greater emphasis on outcome-driven investing and management of short fall risk are other major themes. The income-driven approach is fuelled by an aging population in Europe, the US and some emerging economies too, as older people demand more income and less capital growth.

Against a backdrop of record low levels of yield among traditional income paying assets, ironically investors are today willing to accept a degree of illiquidity, with higher spread risk but higher income paying assets, such as infrastructure or properties, catching investors’ attention again, he explains.