2022 has been a challenging year for investors. After more than three decades of falling interest rates, lowering inflation, economic growth and geopolitical stability, everything has changed. The confluence of factors behind the change point to a sustained cyclical change not seen since the 1970s.
The impacts of these changes are long-lasting, which we examine later. Because the consequences are likely ongoing, it bodes poorly for the strategic asset allocation model dependent on modern portfolio theory that uses historical asset performance as the basis of portfolio construction. A forward-looking approach is needed now because we are at a secular point of inflection.Change
The core drivers of inflation and interest rates are currently weighted towards supply-side constraints and global energy prices. Everywhere you turn, from the supermarket to construction, prices are rocketing upwards, and things aren't working so well anymore.
Why is that? The core driver of energy prices and supply-side constraints is geopolitical tension. Russia's invasion of Ukraine, the pressures this is placing on its relationship with western Europe and their allies, and Russia's pull-back on gas supply have sent energy prices souring. Also, China's more assertive approach and prolonged COVID lockdowns have disrupted supply chains from 'the world's factory'.
Of course, these core aspects have many flow-on effects, but let's stick with them for a moment. Even if the changes in the behaviour of these two countries were reset tomorrow, we're not returning to where we were.
On energy, the developed world has learned that Russia is no longer a suitable partner, and citizens demand that their governments not just turn the other cheek. Plus, there has been a lack of investment in cheaper and more reliable base-load energy sources. But that's now changing rapidly, driven by pressure from a strong ESG movement to reduce carbon emissions. Therefore, energy supply markets are in the early stages of a long rebuilding process. These factors will likely place long-term pressures on energy market costs and inflation.
On product and component supply from China. Over the past two decades, the world has focused on building highly efficient supply chains within a generally cohesive geopolitical environment. But now, trust has been lost in that approach. Single sources of supply are now considered too risky. So, like energy markets, supply chains for products and components are also being rebuilt.
The combined effects of the structural changes to energy markets and supply chains will be disruptive, expensive, and long-lasting – not least because of their scale.
While we work through these issues, inflation may ease, but if so, it will be primarily due to many developed economies falling into recession. So, it's the devil or the deep blue sea.
Strategic Asset Allocation
Strategic asset allocation (SAA) is a portfolio strategy in which the investor sets target allocations for various asset classes and periodically rebalances the portfolio. It is well suited to a buy-and-hold or hands-off approach to investment. The historical risk-return outcomes of primary asset classes drive SAAs allocations.
During extended periods of stable and favourable economic conditions, SAA works a treat. Modern portfolio theory can hold true over long periods. For financial advisers, its simplicity makes it easy to manage, particularly if driven by the standard practice of risk-tolerance-based portfolio design, which is what most advisers in the industry are trained to do.
However, during times of extended adverse economic circumstances and high volatility, SAA is at high risk of failure.
- Expensive equity and property markets, driven up by a decade of easy money, are creating a high probability of markets reverting to longer-term averages, either through a hard and fast correction or over an extended period
- With potential losses on the cards, the time horizons for most financial advisers' clients are shorter than the 'don't worry and wait' principle that underpins modern portfolio theory. Most investor clients don't have the time or patience to wait for the rebound
- Leading investors know that the best way to make money is not to lose it. Volatility itself is the enemy of returns, particularly over shorter timeframes.
SAA largely ignores prospective risks and returns. It's not a clever way to face up to a crisis and a likely period of poor or uncertain returns. Even Markowitz admitted that Modern Portfolio Theory fails under certain conditions. Studies such as those outlined by Schroder's in their paper "Why SAA is Flawed" suggests it can fail a typical balanced investor 47% of the time over 10-year periods. Advisers should not accept those odds when acting as custodians of their client's life savings, nor the business risk an outcome like that would likely result.
Focus on the Future
Institutional investors have been using outcomes-based active portfolio management for decades. Why? Because aiming for a specific risk-return outcome delivers lower volatility and greater certainty of achieving time-weighted results.
In today's world, focusing on the future makes more sense for superannuation and other retail investments. Actively managed portfolios utilising Dynamic Asset Allocation (DAA) are forward-focused. Investment managers concentrate on the future performance of individual assets rather than asset classes. Plus, greater diversification is available through alternative assets, such as commodities and resources, which reduces reliance on underperforming equities and bonds. By design, it aims for and often delivers lower volatility and reduces risk.
Until recently, financial advisers and their retail investors had no alternatives to SAA available through retail portfolios. Today, it is available through specialised Dynamic Asset Allocation portfolios, such as those offered by Dynamic Asset.
For advisers and their clients, portfolio administration is simplified through a combination of managed accounts and professional portfolio management services offered across various administration platforms. SMAs and MDAs provide better outcomes from faster, real-time changes to portfolio allocations with the added benefit of far lower levels of administration by the adviser.
Dynamic Asset can help
Dynamic Asset delivers turn-key solutions for advisers to deliver DAA portfolios. Contact us to learn more about the benefits available to you and your clients.
