The challenges of asset allocation

By Jayson Forrest - Managing Editor  - IMAP Perspectives

There is no denying that asset allocation is a very demanding discipline to do consistently right. Michael Karagianis - a Senior Consultant at JANA - says industry evidence suggests there are not many practitioners who have good long-term records in delivering positive value, such as risk reduction, in their asset allocation process.

“There is a significant difference between having a view on asset allocation and actually having to run it within a portfolio,” Michael says. “To do asset allocation right is tough, even for professional asset allocators, let alone financial advisers.”

Michael spoke at length about the challenges and difficulty of successfully running an asset allocation process with the Chief Investment Officer at Infinity Asset Management and Viridian Advisory, Piers Bolger, and the Head of Investments at MLC, Al Clark, at the 2021 IMAP Portfolio Management conference,.

“I agree that asset allocation is undeniably hard,” says Piers. “The challenge we see around asset allocation is you need to have a process around your asset allocation framework, which underpins your ability to deal with different market environments, and achieve the objectives you have set.”

Infinity Asset Management uses four key pillars as the foundation of its approach to asset allocation:

1. A process around the asset allocation framework. This supports Infinity’s ability to deal with different market environments, allowing it to make changes to its asset allocation, whether that’s manager selection or securities selection.
   
   
2. This is the ability to implement on portfolios across the client base at the same time. Using managed accounts has meant that implementation has become a significant advantage compared to more traditional advised portfolios, where advisers rebalance client portfolios starting with their biggest client and then working their way down the client list. The advantages of implementation through a managed accounts solution means advisers are able to manage all their clients portfolios at the same time.
   
   
3. A broad church in your investment universe. Infinity believes in being able to get as granular as possible with its investment selection, without over diversifying portfolios.
   
   
4. Add value. It is imperative that the asset allocation process actually adds value for the client. Results need to be measurable, to ensure value is being added.

“Quite often, practitioners view asset allocation as having to be a significant move or adjustment every time they need to rebalance a portfolio. However, we don’t view it like that. Instead, you need to have a directional view with your asset allocation and a strong belief in your decision-making,” Piers says. “That’s because markets never consistently behave in a normal manner. So, the ability to make changes and manage risk in portfolios is important.

“In fact, when we think about growth and defensive assets, there are some asset classes that have some significant income generative capabilities, as well as asset classes that have quite low interest rate sensitivity built into them. When building out our asset allocation, whether it’s defensive and/or growth, we look to combine these elements.”

Al Clark agrees that as a starting point with asset allocation, investment professionals need to be honest about where they can truly add value to the asset allocation process. He acknowledges that the investment environment is currently challenging, making asset allocation particularly difficult, requiring professionals to be more innovative in how they approach asset allocation.

However, Al concedes that while asset allocation is not easy, he admits it has been easier in the past.

“Previously, when you made the decision to move out of certain assets into other assets, there was always something on the other side to move into. But right now, there is nothing on the other side to move into,” he says. “For example, if you want to get out of growth, there’s nowhere else to go. So, that’s why it’s currently a very challenging environment for asset allocators.”

To address this challenging environment, Al believes financial advisers and asset allocation professionals need to become more innovative in how asset allocation is approached. This includes how to deliver yield at a time when the majority of assets that advisers traditionally invest in, are not providing the type of yield to clients that they have come to expect.

“So, from that context, asset allocation is challenging,” he says. “At MLC, we actively manage the asset allocation process to position our portfolios for evolving risks in markets and economic conditions. By doing so, our approach gives us the flexibility to customise the portfolios’ building blocks to deliver better returns and reduce risk. By utilising our proprietary Investment Futures Framework, we build portfolios that consider many types of futures and scenarios."

In the current environment, where returns are harder to come by, Michael believes you can either go two ways with asset allocation. He says you can either be more frequent and almost take a Global Tactical Asset Allocation (GTAA) approach to investing, or you can be more discretionary about it - taking a lesser number of higher quality positions.

 It’s the latter approach that Piers takes to asset allocation at Infinity Asset Management.

 “At the moment, we’re seeing a lot of one-way positioning across portfolios, which can be challenging. At Infinity, we are more discretionary about our asset allocation, rather than being in the high frequency trading camp.” And why is that? “Because we’re not good enough to be high frequency traders and to be honest, we don’t think it adds value.”

And what about Al’s approach to asset allocation? Again, he says it comes back to where you think you can add value.

“Over the years, I’ve learnt that I’m no good at short-term trading, so that’s something I can’t add value to, but there are other people who are very good at it. So, you need to be honest about where you can add value, which I believe is very important in your approach to asset allocation,” he says.

However, he adds that advisers shouldn’t be afraid to take on risks when they think they can add value, but only if they’re nimble enough to take on the risk.

Piers also believes it is important to have a rationale to support your asset allocation decision-making.

“A rationale allows you to structure your thought-process around asset allocation, like: why are we making our decision; how are we making it; what is the duration; and what is the catalyst for changing our decision,” he says.

 “From an asset allocation viewpoint, it has been helpful for me to really think about our rationale for asset allocation, which includes clearly documenting it and embedding that rationale into the asset allocation process. Having a framework like this means that in the event of getting something wrong with our asset allocation, we can work out the implications of our decision on the overall asset allocation of the portfolio.”

As an investment structure, managed accounts offer advisers and investors many advantages. But Al believes it is important that practitioners remember there are also constraints with asset allocation when using managed accounts.

He says advisers are restricted by the funds available on platforms, but adds that with the democratisation of investing, advisers now have greater access to many ETFs and other listed vehicles that provide them with the capacity to get most of the exposures they need for portfolios.

For Piers, it’s all about accessing alternatives and the difficulty he has incorporating this diverse asset class into Infinity’s managed accounts due to liquidity issues.

He points to the difficulty many industry superannuation funds recently experienced with the “significant amount of illiquid alternative assets as part of their asset allocation, which was challenging for them to manage”, as Australians were granted early access to a portion of their superannuation as part of the Government’s COVID-19 early release of super program.

In a zero or low interest rate environment, how do you build a portfolio that delivers yield?

“It’s a good question,” says Al. “You need to have a ‘broad church’ of investment options and be willing to look for different ways of delivering yield. For example, we’ve got Chinese bonds in our portfolio that are paying a 3 per cent yield. That’s 2 per cent more than any Government bond in the developed world, so it makes sense to invest there.”

Al also says you need to consider the defensive aspect of building portfolios, which can be achieved through defensive assets like currency. “And while it is challenging for managed accounts, there are vehicles, like ETFs, that you can get into your portfolio that provide you with the types of exposure you’re after.”

In comparison, Infinity has increased its exposure to alternatives, including infrastructure and real assets. Yet, despite this, Piers continues to believe that equities still provide a strong yield.

“There’s no denying that asset allocation is challenging in the current environment, and if yields continue to go the way they have been over the last three months, then the fixed income component of our portfolio will generate a negative return. So, that’s something you have to be mindful of,” Piers says.

“For retirees or your conservative clients, that might result in a difficult conversation, because these clients really haven’t seen similar market conditions since 1994.”

Piers Bolger is the Chief Investment Officer at Infinity Asset Management and Viridian Advisory; Al Clark is Head of Investments at MLC; and Michael Karagianis is Senior Consultant at JANA.