Asset allocation is often described as one of the most important determinants of investment outcomes. But while that statement can be true, it may also be somewhat obvious and, in some circumstances, incomplete.
A Google search for “the importance of asset allocation” led with a Morgan Stanley article titled Asset Allocation 101: What It Is and Why It’s So Important. It introduces the subject through the familiar advice not to put all your eggs in one basket:
“The process of dividing your portfolio among different categories of investments, or asset classes, is called asset allocation.”
This makes intuitive sense. Diversification involves owning different types of investments that respond differently to economic and market conditions. When one investment is performing poorly, another may provide stability or positive returns.
They go on to identify four broad asset classes: equities, bonds, cash and alternatives. Equities offer higher return potential but also carry greater risk. Bonds are generally expected to produce lower returns with less risk, while cash has traditionally offered the lowest risk and lowest long-term return. Alternatives, meanwhile, are presented as higher-risk investments that may provide qualified investors with exposure to return streams that are not necessarily correlated with conventional markets.
The article concludes by repeating its central proposition:
“Asset allocation is one of the greatest determining factors in your investment outcomes.”
Is asset allocation simply stating the obvious?
I have always thought that describing asset allocation as ‘one of the most important drivers of investment outcomes risks stating the obvious.
If a portfolio is constructed according to the broad risk-and-return characteristics of equities, bonds, cash and alternatives, then of course its return will be heavily influenced by the proportions allocated to each. Given the historically lower long-term returns from cash and bonds – and, in New Zealand at least, the relatively small allocations traditionally made to alternatives – we might express the point more directly: For many conventional portfolios, the greatest determinant of returns is simply how much is invested in equities.
Investing more or less in bonds is only influential if this simultaneously changes the equity or alternatives allocation. Whether you have 20% in cash and 30% in bonds or 10% in cash and 40% in bonds will make very little difference. Under a traditional asset allocation framework, the big decision, the one that matters, is how much you have in equities.
The missing element: investment skill
The problem I have with this approach to portfolio construction is that it leaves out a critical part of the equation, investment skill.
The conventional asset-allocation framework tends to treat equities as a single source of risk. It generally assumes that an allocation to equities will deliver something resembling equity-market risk and return, with limited allowance for a skilful manager to reshape or reduce that risk and/or generate much higher returns.
Yet in almost every risky endeavour, skill matters. Whether it be driving a formula one car, building a high-rise building, climbing a rock wall, open heart surgery or investing in the share market, skill greatly reduces the risk of each one of these.
The question then becomes, where can I find these skilful managers, and importantly how do I know their skill will persist.
In our experience at Saxe Coburg, the clearest examples of genuinely skilful investors can be found within the “alternatives” universe. Here I do not define alternatives solely as private equity, infrastructure, property, collectibles or other non-traditional assets. I also include the skilful management of capital across equity, bond, commodity, currency and derivatives markets, using strategies whose returns are not determined primarily by whether markets rise or fall.
A manager may, of course, operate within a recognisable asset class often categorised as alternative. New Zealand-based Morrison & Co, one of the worlds leading infrastructure investors, which manages NZ listed company Infratil, is one example. But the mixed performance of infrastructure funds more generally suggests that the label alone tells us relatively little. Investing in infrastructure does not guarantee an attractive outcome. The quality of the manager is the differentiating factor.
Asset class or manager?
This leads to the central question: Which matters more – the asset class or the investor operating within it?
If your available universe is traditional active funds which rely on stock selection alone to beat the market, either by being less volatile or by making higher returns, it is a very difficult task. The equity market is incredibly competitive and the daily auction pits one person against the other, every institution, sovereign and pension fund against the other. For every buyer who thinks a stock looks cheap there is typically a seller who thinks it looks expensive, all things being equal. This describes the discretionary investor who are the true price makers as opposed to the passive investor who is price agnostic.
You have costs which drag on your performance, so you have to be well above average just to match the low-cost market tracking index funds. Few achieve meaningful outperformance persistently over long periods of time, and that is why under this scenario, the asset class you choose becomes the most important thing. You may of course be a direct investor, selecting stocks yourself or with the help of an advisor, and your success will come down to the same question, do you/your advisor have the skill to generate better returns than the market or other skilful fund managers.
The equation changes when investors move beyond traditional long-only funds and into genuinely differentiated alternative strategies, where returns depend less on broad market direction and more on the manager’s decisions. Investing becomes less about allocating among asset classes and more about allocating to people.
That does not make the task easier. In many respects, it makes it harder. Manager selection requires investors to assess whether past returns reflect repeatable skill, favourable market conditions, hidden market exposure, leverage, illiquidity or simple luck. It also requires careful consideration of fees, governance, transparency, capacity, operational risk and alignment of interests.
Nevertheless, if an investor can identify differentiated and repeatable skill, manager selection will be the most important determinant of portfolio performance
Rethinking the role of alternatives
For portfolios built around a traditional asset-allocation framework, the biggest decision is often how much to allocate to equities and how much to diversifying alternatives.
But making a meaningful allocation to alternatives requires a change in mindset. Alternatives should not be treated as a single homogeneous asset class. The category includes everything from highly leveraged and illiquid investments to conservative strategies designed to preserve capital. Two alternative funds may have almost nothing in common.
The key question is not merely, “How much should we allocate to alternatives?” It is:
Which managers and strategies provide genuinely different and durable sources of return, at an acceptable level of risk?
If an investor has demonstrated skill in answering that question, portfolio construction begins to move away from a purely asset-allocation mindset and towards a manager-selection mindset. That is where the potential difference lies.
What do we mean by risk?
One final point concerns the claim that alternatives carry the highest risk.
It is a broad generalisation which we hear often. But in the context of investing, “risk” has more than one meaning. It may refer to volatility, illiquidity, leverage, drawdowns, permanent loss of capital or the possibility of failing to meet an investor’s objectives. Alternatives cannot be ranked collectively as either more or less risky than equities without first establishing which type of risk is being measured and which alternative strategy is under consideration.
Some alternative strategies have experienced lower volatility and smaller drawdowns than equity markets. Some have also provided valuable diversification because their returns have not depended on rising equity or bond prices. Others have produced severe and permanent losses despite appearing stable beforehand.
The relevant distinction is therefore not simply between traditional assets and alternatives. It is between return streams that are genuinely diversified and those that attempt to participate in risky strategies without the requisite skills.
The bottom line
Asset allocation remains important. In a conventional portfolio dominated by equities, bonds and cash, it will explain much of the investor’s experience, particularly the level of equity market risk accepted.
However, when investors gain access to genuinely differentiated strategies, and when they possess the ability to identify skilful managers, portfolio construction becomes more than a decision about asset classes. It becomes a decision about where skill exists, whether it is repeatable, and what risks are being taken to produce the returns.
For traditional investments, your weighting to equities may be the most important decision.
For genuine alternatives, selecting the right people (manager) is the most important decision.
If you’d like to discuss the topics covered in this article, please get in touch with Mark or Sam or contact us for a discussion on how we could support your wealth journey.
Managing significant wealth today is more complex than ever. Market volatility, slowing property returns, and limited traditional options mean yesterday’s strategies may not be enough to protect and grow what you’ve accumulated. Check out ‘The Alternative Advantage’ which outlines how alternatives can strengthen your portfolio and give you greater confidence about the future.
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