For the last forty years, the world has changed dramatically. The Bretton Woods system’s collapsed, energy crisis emerged, the Berlin’s wall fell, technology transformed our life and massive deregulation changed the face of the world. But somehow, the way of multi-asset class is understood stayed immune and perfectly hermetic to this. As a consequence, portfolios constructed accordingly perform poorly and face bleak prospects. What are those drivers that are being ignored? What possible alternatives to envisage? What possible outcome to expect from understanding the tectonic shifts that occurred? This paper strives to provide some answers to these questions by reflecting critically on the current widely acknowledged multi-asset class management.
Multi-asset class management (MAC) has been seen for a very long time as an expression of pension management only. With the development of family offices and other structures, the expression of MAC has become more diverse. Mainly, today such activity can be split between long-only investors such Pension funds and absolute return investors. Both are seen as different animals with different ways to see an asset allocation. Indeed, legislation can bring different restrictions or freedom. Of course, the risk profile can be different and drive strategy on different investment supports. However, I cannot see why one investment approach could not be used by long-only fund and absolute return funds in the perspective of multi-asset class management. As I believe the distinction long-only and absolute return has no justification in terms of investment decision. However, to limit the scope of the topic, I will focus essentially on what should be considered as an asset class. What diversification would be good enough to build a product able to perform on a long-term basis in any economic circumstances?
The starting point
I believe each investment process should start by designing the target and risk it wants to achieve. As mentioned in a previous paper, if the idea of a benchmark is almost universal in the investment world, the idea is seriously wrong. Benchmarking yourself against a peer group instead of against what you need to achieve is clearly wrong and it can explain why most of the pension funds around the world are in a critical position today.
Second, the choice of asset classes should be done according to their intrinsic attractiveness regarding the macroeconomic situation and according to the risk/target goals. What is the point for pension funds to invest in assets which are not going to match their targets? Why investing in developed economies fixed income for the next ten years? Likely, a pension fund will need to achieve between 7% and 9% to cover its futures liabilities. Who things that UK, euro, Japanese or U.S. bonds would deliver such results? The answer is easy: no one.
For an absolute fund, what is the point to invest in Neutral equity strategy which for the last decade until September 2013 has delivered 0.97% annualised performance, according to the HFXR index?
One argument for a positive answer is the correlation. For many professionals, to be considered as a separate asset class, an investment must behave differently than all other assets. Indeed, it is not helpful to invest in assets with a similar return and consistently strong correlation. So the idea is to invest in different assets with different correlation. But unfortunately, it is not easy for longer periods of time to look for different assets de-correlated. We cannot use historical correlation to build a multi-asset-class product which will be able to perform in any economic circumstances. It would be an easy job, but unfortunately statistics data is not good enough to give us a positive answer. Correlation gives us a statistical idea of a relationship between different assets. The most common and known example is the couple equity/bond. Indeed, usually, when the first experiments a downtrend, the second is going to the opposite way. Between 1926 and 2004, U.S. bonds earned a positive return in 24 of the 26 years the SPA 500 declined. But on the same period, no over straight correlation can be demonstrated.
The current industry standard
In the US, the Yale model is still predominant in organising the asset allocation. The portfolio is split between six different types of investment: domestic equities, foreign equities, private equity, real assets (usually property), absolute return funds and bonds. The Yale endowment is no longer allocated equally, for investment strategy reasons but also for technical reasons. It can be difficult to allocate a huge amount of money to private equity. The idea of the multi-asset-class product is to lower the risk by the diversification. Logically, any multi-asset class strategy is looking to invest in assets with lower correlations that still meet return objectives. Today, do U.S. managers get diversification between domestic and foreign equities? Are absolute return strategies de-correlated from long-only strategy, particularly for equity?
In Europe, pension manager usually splits their investment into four different asset classes: Bond, Equity, alternatives and a fourth category which differs according to the different houses and where different investments like corporate, debt, private equity or real estate could be found. Does this split make senses today in an environment of falling correlation and economic changes?
Bonds as an asset class
The Barclays US, Govt bond returns an average yearly performance of 8.73% from 2000 to September 2013. The Barclays Euro Govt bond returns for the same period 7.21%. But for the period 2009-2013, both indexes printed respectively 1.63% and 1.33%. Clearly and not surprisingly, the trend is down. Unfortunately, current bond yields are so low that future bond returns will have a hard time matching even the lower performance of the most recent decade. It’s the reason, as I mentioned few times in previous papers and discussion, I cannot see the point, from an investment point of view, to include bonds from developed economies in any pension universe. Indeed, some liability issues or cash needed could justify some bonds in a portfolio. But this part should be calculated according to the cash ratio instead of risk asset allocation ratio.
The future does not look bright for bond markets. The FED, from acquiring debt in the 2008 rescues of Bear Stearns and American International Group to three rounds of quantitative easing, brings its balance sheets over $3.85 trillion so far. At the current balance-sheet level, an interest rate of 4.9% would be sufficient to wipe out the Fed income. If the balance sheet grows for another year, the rate that causes interest on reserves to produce a loss falls to 4.3%. Chairman Ben S. Bernanke said in June the central bank would hold on to the debt after Fed economists led by Seth Carpenter, a senior associate director in the Board Division of Monetary Affairs, said in a January paper that the institution was on course to lose an unprecedented amount of money and might be unable to remit a profit to the Treasury for as long as six years. He found the Central Bank can continue to have earnings by never selling these securities, as long as the benchmark federal funds rate gradually climbs from near zero to 4% by 2018. In clear, if the economic situation improves, the FED could lose a huge amount of money because interest rates will increase. If the situation does not improve, the FED would continue its program, aggravating the issue. It is a catch 22 which likely is going to bring interest rates at very low levels for an extensive period of time.
Corporate bond performances did not show exceptional result too. The Dow jones corporate bond index returned an annualised performance of 1.49% between the period 2000-Sept 2013 and 1.32% from 2009 to Sept 2013. The HFRX Fixed Incomes corporate measuring the hedge fund for corporate bonds had a quite poor performance too between 2007-sept 2013 to 1.79%.
Traditional equity is not the solution
After rising at an annual rate of about 15% over the period 1981 to 2000, US stocks returned an annual average of 2% from 2001 to 2010. At the same time, volatility increased from 14% during the earlier period to 19% during the more recent decade. In Europe, during the period 2000- Sept 2013, European indexes printed also very poor annual average performances. On the period, the DJ Stoxx 600 made 1.01%, the FTSE 100 0.84% and the DAX 5.03%. High inflation rates drove up interest rates and eroded bond values during the 1970s. In response, many institutions shifted their portfolios to include larger equity positions. Pension funds, in particular, made this shift after getting caught between quickly rising inflation-indexed liabilities and falling nominal bond values. Equities provide better inflation protection than nominal bonds, but they also carry much higher risks during non-inflationary periods. The extended equity rally from the early 1980s to 2000, made this shift appear attractive. Part of the equity rally was driven by declining interest rates. However, since 2000, equity has printed very poor performances.
Derivatives are not an asset class
At a time of low return expectations for traditional assets, institutional investors strive to increase returns by seeking alpha from alternative assets, like hedge funds, instead of relying only on beta from traditional assets. So in Europe, mainly we saw emerging a new asset class called ‘Alternative’ or ‘absolute’ return strategies supposedly uncorrelated with returns on traditional assets. In reality, some hedge fund strategies have material exposures to traditional asset classes, while other strategies deliver returns that are largely uncorrelated with traditional assets. With the time and few accidents, big allocators have increased the level of their due diligence. Before good performances, known names were enough to attract funds. Today, the first driver is not anymore performances, but organisation, structure, assets under management, risk management. Due diligences have become more sophisticated and more selective. Sometimes, it happens at a cost of lower performances and not necessarily lower risks. However, most of the asset allocators are still putting all different animals as private equity, real estate, long/short equity, bond, commodities, trend following, neutral strategy, multi-asset… in the same cage called ‘alternative’. But alternative assets are not a homogenous asset class and I would say they are not at all an asset class.
A fundamental approach
You do not create or change asset class each day or each year. But some geopolitical or economic events can change the correlation of asset-class. On the last forty years, five big events have created long-term waves bringing volatility and changing the face of the financial world for at least a decade. The consequences of some of them are not completely understood yet. But these events should drive the process to pick up the asset class.
- August 1971 and the suspension of the convertibility USD-Gold. The end of the Bretton Woods system (1944), fixed exchange rates based on the U.S. dollar, which was redeemable for gold by the U. S. government, brought huge volatility in the financial spaces with global consequences. For Paul Krugman, the crash of 1987 is a direct consequence of this decision. Because the Federal Reserve is not obliged to tie the dollar to anything. It can print as much or as little money as it deems appropriate. Above all, the Fed is free to respond to actual or threatened recessions by pumping in money. For sure, the end of Bretton Woods’s system has changed the face of the financial market by increasing massively volatility. The costs of this volatility are hard to measure (partly because sophisticated financial markets allow businesses to hedge much of that risk), but they must be significant.
- The Oil crisis in 1973: the OPEC embargo following the Yom Kippur War changed the face of the world forever. For instance, the 1973 oil crisis was a major factor in Japan’s economy shifting from oil-intensive industries and resulted in huge Japanese investments in industries such as electronics. The Japanese automakers also took advantage of this embargo. After they realised what fuel costs were in the United States, they started producing small, more fuel-efficient models, which began selling as an alternative to ‘gas-guzzling’ American vehicles of the time. This triggered a drop in American auto sales that lasted into the 1980s. The Developed nations cut interest rates sharply to encourage growth, deciding that inflation was a secondary concern. The result was a stagflation situation. The price shock created large current account deficits in the oil-importing economies. A spontaneous petrodollar recycling mechanism was created, through which the surplus funds accumulated by OPEC nations were being channelled through the capital markets to the West to finance the current account deficits. The functioning of this mechanism required the demise of capital controls in the Western oil-importing economies and it is seen by scholars as the beginning of an exponential growth of the capital markets in the West from the 1970s onwards. Discussions of the long-term consequences of the oil crisis are still going on. But definitively, implications have been huge and have changed financial markets and had implications on the way to manage funds.
- The fall of the Berlin’s wall in 1989: the twentieth century ended with the fall of the Berlin’s wall. With it, socialism and communism alternatives to capitalism disappeared. Eastern Europe, China and India turned to new economic systems where about 2.3 billion people invited themselves to the table of capitalism. Could we consider multi-asset class management in the same way after such important event which changed the face of the world?
- The explosion of computer and internet in the 1990s: the speed of information increased dramatically. The way to work in all industries has been impacted in all possible ways: organisation, structure, human resources, marketing or finance. New business models appeared other disappeared. We did not see yet all implications of this revolution.
- The Gramm-Leach-Bliley act in 1999: likely we would have never heard about “too big to fail” without the suppression of the Glass–Steagall Act of 1933, removing barriers in the market among investment and retail banking. But on the other side, the U.S. would not have enjoyed such a long period of prosperity in the 1990s without this new legislation bringing massive deregulation in the financial industry. The impact of the deregulation is still discussed by economists and I will not take part in the debate. But likely, the terms ‘subprime mortgage’ or ‘easy quantitative tools’ would not be here without the end of the Steagall Act. The impact of the FED monetary policy is going to have a very long legacy.
These economic or geopolitical events have changed the face of the economic world but they did not have any implications about the way big asset management companies consider MAC. Is it not extraordinary? The end of Bretton woods system’s brought huge volatility across all assets classes. The oil crisis changed the economic faces of the world developed economies, making the first serious warning about natural resources needs. The fall of Berlin’s wall marked the beginning of the conversion of emergent economies to the developed economies standard with all its implication including a huge need in natural resources. The technology revolution created a new economy and reinforced the globalisation. The deregulation in 1999 has just started to show all its effects after the biggest financial crisis since 1929. All these events should force any financial thinker to review the asset class included in his portfolio. Despite these massive changes, the Yale model and the Capital Asset Pricing Model (CAPM) are still the predominant ideas. Even so beautiful theory construction cannot resist to the reality and changes.
An asset allocation proposal
The Yale model and the European split should be reviewed considering the new realities of this world. But also as mentioned before, the asset class should be chosen according to what you need to achieve and your risk profile.
- Bond: as mentioned before, an allocation cannot be justified by investment reason, but by liabilities, cash duties or regulation.
- Equity: A distinction can be done between three different subcategories: the developed markets, the emergent markets and the alternatives equity products or the long-short strategies.
On long term basis, all equity markets are not correlated. From 2000 until 2013, large cap in the developed economies printed very poor annualised performances. Except South Korea and Malaysia, which by the way were not considered as developed economy in 2000, only Australia could print a performance over 5%. The Spa 500 made a poor 1.05%, the UK is quasi-flat 0.22% and the Euro area is negative -2.78%. At the opposite emergent economy printed outstanding performances in all part of the globe: Russia +51.76%, India +19.8%, Brazil +15.95% and China +9.09%. In average, the annualised performance is 20.03% for the emergent markets against 1.86% for the developed economy. For the period 2006-2013, emergent economies are still beating developed economies 7.24% versus 1.22%.
Surprisingly, alternative equities are not doing so well. From 2000 until 2013, the equity hedge index printed an average yearly performance of 3.54% only. However, the volatility of alternatives is twice less important than long only.
On Equity, diversification could be also done by using small or mid- cap. The S&P mid-cap printed annualised performance of 13.07% and the S&P small-cap 15.07% from the period 2000-2013. In both cases, volatility is lower than the large caps. For the period 2006-2013, small and mid-cap beat large caps with a similar volatility. Even since 2009 and the end bear markets, small and mid-cap have over-performed large caps: respectively 9.18% and 9.53% versus 4.72%.
Likely, the convergence of emergent markets to what is today the developed economy will continue. It means that emergent economies will continue to outperform developed economies. Globalisation likely will play a smooth role, bringing down volatility in the emergent economies. Malaysia and South Korea are on the side of the developed economy. Without the terrible earthquake in 2012, Chile will be too. Indeed, geopolitical instability, social issues could time to time slows the process of conversion. But this process is irreversible and it will continue for the next twenty years: Brazil, Mexico, China, Indonesia, Philippines and Turkey will be the engine growth of the world. In the developed economy, in an environment of low-interest rates, small and mid-cap will continue to outperform large-cap. Some countries with natural resources exposure will also do particularly well: Malaysia, Australia, Canada or South Africa.
- Property: a global exposure is more than suggested in the world of tomorrow. With half of the population living in Asia, this part of the world would be under continuing pressure. Overall, property remains an asset class not completely correlated to equity and performing well in an environment of low-interest rate.
- Commodity: you can find inside the commodity a lot of diversification and this asset class can be subdivided into different categories: Energy, Agriculture, non-precious Metal, precious Metal, gold, natural resources… Commodities are going to be the big story of the twenty-first century. Increasing needs from emergent economies as China or India, world population growing, climate change and energy penuries are going to weight on the history of this century.
- Global Absolute strategy: this asset class includes all CTA, hedge funds strategies investing in different asset classes like Global Macro, event driven, convertible arbitrage or systematic trading strategies.
Private equity: the access to private equity can be tricky, but according to the legal restrictions and/or the target objectives you want to achieve, private equity should be considered as a separate asset class. The de-correlation with equity is disputable. However, its non-liquid characteristic and the difficulty to make an annual valuation are making it a special and different asset class.