Read this article to understand:
- The importance of the strategic asset allocation in a portfolio strategy
- How diversification can help deliver smoother returns in changing market conditions
- Why volatility should not be the standalone measure of risk in portfolio management
May you have a strong foundation when the winds of change shift…
In recent years, those of us managing money have seen more than our fair share of unforeseen market events: the COVID-19 pandemic, Russia’s invasion of Ukraine and the unprecedented rate-hiking cycle that followed it, not to mention the volatility that seized markets over the summer of 2024.
This reinforces the importance of acknowledging that what we don’t know often has far more importance than what we do and the importance of humility in considering investment risks.
The first rule of investment advice: Understand risk
Understanding a client’s relationship with risk is also at the heart of providing sound financial advice. An adviser needs to balance each client’s risk tolerance with that of their risk capacity. This means exploring their investment objective and time horizon alongside an array of other considerations: from liquidity needs to tax considerations, as well as preferences such as individual ethical or sustainable investment concerns.
A good financial adviser will consider all these factors when instructing clients and will often act as a behavioural coach, laying out the rationale for an investment policy that gives the client the best chance of achieving the returns they desire within appropriate risk parameters.
Advisers then need to find a fund that has the right risk profile. Using fund ratings allows them to filter for funds using broad parameters such as performance, risk scores, alpha and volatility, which helps them simplify the fund evaluation process and find the right solution for clients. For instance, in most of Aviva Investors’ multi-asset ranges, we supply a range of five funds, each with its own volatility target and usually an independent risk rating, to help investors match their fund choice to their attitude to risk (see Figure 1 for an example of our MAF Core range).
Figure 1: MAF Core range
Note: This diagram is for illustrative purposes only, asset allocations are subject to change.
Source: Aviva Investors. Data as of September 29, 2024.
In this article, we explore the three fundamentals that we believe make for a solid foundation in multi-asset funds.
Firstly, we look at the importance of a strategic asset allocation for fund performance. We then look at the concept of the “efficient frontier” and how diversification can help outcomes by improving this frontier. And we conclude with some remarks on why we believe investment risk goes beyond volatility – often the most-used risk measure.
Why is a strategic asset allocation important?
The strategic asset allocation (SAA) is essentially a “portfolio strategy”, where we set long-term target allocations for various asset classes based on our expectations of their risk-return attributes to meet a fund’s volatility target.
As we have seen since 2022, interest-rate risk and inflation are some of the key market risks
The target allocations depend on several factors captured at the risk-profiling stage, such as risk tolerance or time horizon, and are reviewed annually. To determine them, we use historical returns and the past volatility of a range of asset classes, alongside interest-rate expectations.
The risk/ return relationship is again at the heart of this approach, particularly to assess any systematic or market risks – risks that can influence the economy and markets significantly.
As we have seen since 2022, interest-rate risk and inflation are some of the key market risks.
What is interest-rate risk?
Interest-rate risk arises when there are changes (or even expectations of changes) in the base rate set by the Bank of England or other influential central banks. Assets like bonds are most vulnerable to this type of risk because their current market value is tied directly to prevailing interest rates: the rate they pay will be more or less attractive depending on how base rates change. For this reason, bond prices typically fall when market interest rates go up and rise when interest rates decline. This is also known as ‘duration risk’, and long-term or ‘long duration’ bonds are more sensitive to it.
Interest-rate risk will also play a role in the performance of other assets, like shares, given the knock-on effect of the level of base rates on the overall economy and companies’ performance. A bus or water company may find earnings are fairly resilient in a higher interest-rate environment, but firms selling goods that customers tend to purchase using loans – such as new cars, which customers may hold off on purchasing until loans become cheaper – may see profits suffer. There can also be a more significant impact on businesses which are borrowing substantial amounts of money to fund long-term growth.
Why is inflation a risk?
Inflation is another example that affects asset prices in a variety of ways. In theory, inflation should be good for shares and bad for bonds. This is because shareholders are entitled to a claim on future company profits, which – if companies manage to pass on increased costs to consumers via price rises – should be unaffected by inflation. Bondholders, on the other hand, are entitled to a series of fixed payments which won’t increase unless the bonds are inflation-linked.
All other things being equal, the real value of the return on shares should exceed that of bonds over a long time horizon, though this can vary at different stages of the market cycle. In 2022, for example, with inflation fuelled by supply bottlenecks rather than blockbuster demand, rate hikes harmed bond prices, but equities also retreated amid a cost-of-living crisis which pinched the purses of most consumers.
It’s all about managing uncertainty
The key takeaway here is managing uncertainty. Uncertainty equates to risk, and while systematic risk is unavoidable and challenging to predict, there are ways to position a portfolio to manage the degree to which it is exposed. That is one factor that helps explain how the funds within our multi-asset ranges target different levels of volatility.
Asset allocation policy is the overwhelmingly dominant contributor to total return
Setting a robust SAA is in fact crucial to delivering consistent returns. Seminal research published in 1991 by Gary Brinson, Brian Singer and Gilbert Beebower found that “asset allocation policy is the overwhelmingly dominant contributor to total return”, a finding which other studies have since confirmed.1,2
For example, Figure 2 shows the performance our SAA has contributed to our mid-range multi-asset portfolio’s returns over time compared to a standard “balanced portfolio” of 60 per cent equities and 40 per cent bonds. But remember past performance is not a guarantee of future returns.
Figure 2: SAA contribution to MAF Core III versus a 60/40 allocation (per cent)
Past performance is not a reliable indicator of future performance.
Source: Aviva Investors. Data as of September 29, 2024.
Aviva Investors has been managing multi-asset portfolios for over four decades, running over £90 billon in multi-asset funds for Aviva, alongside our external clients. This scale enables us to have a committed in-house team that manages our SAA process.
Diversification: The only free lunch
Investing also entails idiosyncratic risks, which are specific to a particular company or industry and not tied to the broader market. Examples include ineffective management, supply-chain weaknesses and/or regulatory headwinds that may impact one industry specifically, but not all. Within a sector, companies that benefit from strong barriers to entry from competitors can be seen as “less risky” than those that do not. Given their idiosyncratic nature, these risks can be mitigated in a portfolio through effective diversification.
The more uncorrelated assets are in a portfolio, the less likely everything is to go wrong at once
In fact, as Nobel laureate Harry Markowitz posited – and as multi-asset investors well know – “diversification is the only free lunch in investing.” This is because the more uncorrelated assets are in a portfolio, the less likely everything is to go wrong at once. Although market risk shows us there is no silver bullet, one key consideration of risk is to adopt a global asset allocation, diversifying across geographies as well as asset classes. In our MAF Core and Plus ranges, we maintain a global exposure to counteract bias to specific countries or markets.
Spreading investments across companies large and small, at home and abroad, in both stocks and bonds avoids the risk of placing all your eggs in one basket and provides exposure to different blends of risk. That is why, over time, a diversified portfolio generally outperforms the majority of those that are more focused. Figure 3 shows an example of the very different risk and return profiles of an array of asset classes.
Figure 3: Range of risk and return profiles of asset classes, 2013-2023
Past performance is not a reliable indicator of future performance.
Source: Aviva Investors, Bloomberg. Data as of September 27, 2024.
Our scale allows us to access assets not typically found in cheaper multi-asset solutions, giving us greater scope to diversify and manage risk. A good example lies within our fixed-income allocation, where using our internal active funds within our MAF Core range provides exposure to riskier forms of fixed income that typically benefit from active management. These include high-yield and emerging-market debt, not commonly offered by peers. Improving the funds’ diversification in this way increases our opportunity to enhance returns for a given risk profile.
We conduct correlation analysis on an ongoing basis
But another key part of effective diversification means picking investments that perform differently from one another in similar markets, allowing portfolios to remain resilient through the economic cycle, come rain or shine. To help build this into portfolios, we conduct correlation analysis on an ongoing basis, to build a portfolio of assets that behave differently from each other in different market conditions, so if one set sees falling prices, another can provide some compensation. That helps maximise portfolios’ expected returns while keeping to the required risk level.
Risk goes beyond volatility
It’s commonplace for multi-asset funds such as ours to provide investors with a selection of funds targeting different levels of volatility. But gauging volatility is just the start of understanding risk.
Volatility is useful because it can be measured, and because higher volatility in the price of investments increases the risk of buying too high or selling too low. Nevertheless, if experience teaches us anything as investors, it is that the bigger risks cannot be quantified. As such, volatility shouldn’t be relied on as a comprehensive proxy for risk.
The extent to which volatility is a risk depends on an investor’s individual circumstances
Even in more usual market conditions, the extent to which volatility is a risk depends on an investor’s individual circumstances. Someone with a long time-horizon, perhaps saving monthly from birth for their children’s university fund, should be unaffected. In contrast, volatility becomes a bigger risk when we are faced with making withdrawals that lock in losses. As we decumulate investments in retirement, the sequence of returns (or their volatility) is critical. We will permanently impair the value of our portfolio if we are encashing units in a dip.
The actual risk for investors is permanent loss of capital. We therefore define risk as the probability an investor will not achieve the goals they have set for their investment portfolio, for which there is no one ‘right’ measure. Beyond volatility, we invest time in scoping out what may happen and with what likelihood, choosing the right risk measures for each asset class and implementing ongoing risk management to safeguard investors’ capital. The aim is to understand the potential risks from various angles and use this analysis to have an informed discussion before implementing investment decisions.
Greater risk doesn’t always mean greater return
Perceived wisdom tells us that the higher returns you want from an investment, the more uncertainty (or risk) you need to take on. While this is somewhat true over the very long term for the performance of risky assets like equities over safer ones like bonds, the medium term is a different story. Figure 4 highlights that, over the ten years from 2013 to 2023, for example, higher risk has not always come with higher returns: some high-risk assets like commodities have underperformed.
Figure 4: Cumulative annualised returns versus risks, 2013-2023
Past performance is not a reliable indicator of future performance.
Source: Aviva Investors, Bloomberg. Data as of September 27, 2024.
Regime-dependency, for example – the link between monetary policy and how asset prices behave – is key. When central banks began implementing a more restrictive monetary policy and interest rates saw an unprecedented succession of increases in an effort to stem inflation, the negative correlation we had typically seen between bonds and equities fell apart. Changing market conditions and behaviours between various types of assets make it important to continually assess the balance of investments across a portfolio, and the risk/ return relationship of each asset.
Scenario analysis can help managers find the right balance between the pursuit of returns and downside protection
In addition, scenario analysis can help assess the probable behaviour of a mix of assets under different conditions, to help managers find the right balance between the pursuit of returns and downside protection.
To test the robustness of our multi-asset portfolios, we conduct scenario analyses on an ongoing basis. We also “sense check” the strategic asset allocation compared to a simple equity and bond benchmark. This is an important step to give us confidence that the portfolio adjustments we make, based on additional analysis, actually deliver a better outcome. This is illustrated by comparing their respective “efficient frontiers”, the asset mix that offers the highest expected return for a defined level of risk (see Figure 5).
Figure 5: Efficient frontiers: Example of MAF Core risk/return profile compared to a simple equity/bond benchmark (per cent)
Past performance is not a reliable indicator of future performance.
Source: Aviva Investors, MSCI, Bloomberg. Data as of September 27, 2024.
Lest the winds of change shift
Of course, investing always entails risk and performance can never be guaranteed. But setting a robust approach to strategic asset allocation, effective diversification and ongoing risk analysis and management provide a solid foundation. These three fundamentals can help us deliver consistent performance in line with each fund’s risk profile in a range of market conditions. Lest the winds of change shift…
