Strategic asset allocation (SAA) is a critical element of your investment strategy. It refers to how much of your capital you allocate across various asset classes when taking a long-term view of your portfolio. SAA drives the bulk of your risk and return outcome over your investment time horizon, which means it’s critical to review and update your SAA when appropriate to ensure your portfolio remains on target to achieving your investment objectives in a risk-controlled manner.
Lonsec formally reviews the SAA for its model portfolios every two years, including most recently in August 2020. The objective of our reviews is to ensure that the Lonsec strategic asset allocation framework remains robust and continues to be effective in achieving the stated objectives of each of our risk profiles in the long term. This has been an extraordinary year in terms of market movements and responses from governments in combatting the COVID-19 pandemic, but ultimately the principles driving our SAA have not changed.
Lonsec provides two sets of asset allocation risk profiles, one set comprising ‘traditional’ asset classes only and another incorporating ‘alternative’ asset classes. Both sets consist of six risk profiles ranging from Secure to High Growth. Lonsec formally reviews these strategic asset allocations every two years, combining qualitative and quantitative analysis.
The following offers an overview of how we have approached our SAA review this year in the wake of the global pandemic, and takes a look at some of the key issues investors should be considering in formulating their own asset allocation.
Take a long-term view
While COVID-19 has thrown up some unique challenges, the changes made to Lonsec’s SAA at this review have been relatively minor in nature. Market corrections are always uncomfortable, particularly while you are still in the midst of one, however it’s important to recognise that crises are relatively common in the context of long-term market behaviour. Over the last 50 years investors have lived through the oil crisis in the 70’s, the ’87 stock market crash, the Asian crisis, the Tech wreck, the Global Financial Crisis, and now the COVID-19 pandemic.
The quantitative impacts of these events are already captured in our long-term risk and return estimates, so it’s important not to extrapolate further. Cash rates have come down and risk premia have widened for most risk assets. This should benefit risk assets such as equities and real assets over cash and bonds. Bonds offer little in terms of expected returns, however they still play an important role in portfolios as risk-off diversifiers.
There have been two major outcomes at this 2020 review. Firstly, we have reclassified direct property as an alternative asset given it shares similar characteristics with other private market assets such as private equity. Secondly, the allocation to global small caps was removed, reflecting not only difficulties in accessing quality products in this space, but also the structural changes taking place where companies are generally electing to stay private longer.
The long-term absolute return objectives for each risk profile were lowered at this review, due to the cash rate being revised down from 3.0% p.a. to 1.7% p.a.. These absolute return targets are indicative numbers derived from the expected cash performance in the long run. Strategic asset allocation involves taking a very long-term view on asset class returns, but more importantly, it is a measure of asset class relativity. It is important to not overemphasize short to medium term expectations when defining a long-term strategic asset allocation framework.
The following table outlines the updated absolute return objectives and suggested investment timeframes for the Lonsec Risk Profiles (for both the traditional risk profiles and those with alternatives):
In order to develop realistic targets and optimise your allocation, you need to determine long-term capital markets assumptions, including asset class returns and volatility, which are forward-looking and are not directly related to current market valuations. Lonsec’s capital markets assumptions are determined through a combination of our own internal valuation models, consensus forecasts from fund managers, historical asset class performance, and our broader investment committee analysis and discussion.
Again, the need to take a long-term view is critical. Stepping outside the current market dynamic requires discipline, especially when news relating to the pandemic is all we hear and read about, but that it is purpose of your SAA.
Optimise your asset allocation
The next step is to optimise your asset allocation by taking your assumptions and efficiently combining risk and return exposures to create portfolios that are most likely to deliver on your target. Lonsec’s optimisation process draws on inputs such as forward-looking long-term asset class returns and historical risk and correlation data to arrive at a recommended set of portfolios.
It is important to note that a traditional mean-variance optimisation process has limitations. Notably, only statistical measures of risk (such as standard deviation) are considered, to the exclusion of other sector-specific risks such as concentration risk, default risk, liquidity risk, and duration risk. Lonsec applies appropriate constraints on selected asset classes during the optimisation process to mitigate these risks within our risk profiles. These are either ‘upper-limit’ constraints to limit the asset class exposures, or ‘zero allocation’ constraints, to eliminate asset class exposures from some of the risk profiles. Apart from these non-statistical risks, Lonsec has also assessed the appropriateness of each individual asset class across our risk profiles. For example, Lonsec considers any emerging market investments in the more conservative risk profiles as inappropriate.
The optimisation process is essential, not only because it makes your portfolio more efficient, but because it limits other potential risks and ensures your portfolio is in the best position to deliver on your objectives. Moving outside traditional approaches and taking a holistic view of your risks and objectives is key.
Test under different scenarios
We have set our long-term assumptions and optimised our allocations, but the job is not yet done. The final step is to test our portfolio allocations under a range of different investment scenarios to make sure our proposed framework is sufficiently robust.
Lonsec analyses how the change in diversification characteristics of asset classes under particular scenarios affects total portfolio outcomes. The optimisation process relies on one set of risk and return assumptions and long-term average correlations. While these inputs aim to capture the likely relationship between assets over the long term, there will be times when these relationships break down or are not as strong.
Certain investment environments can result in changes to the relationship between assets, which was seen during the GFC when many asset correlations increased. Lonsec generally considers different investment environments, such as inflationary, low economic growth, and market stress/crash, to see how the proposed frameworks behave. Lonsec also conducts forward-looking Monte Carlo simulations for each of its risk profiles, which generate a large number of simulated return paths based on different sets of underlying assumptions.
The primary purpose of the simulations is to examine not only the average simulated return and risk, but more importantly understand the value at risk of our risk profiles. The chart below displays the deviation in expected annual returns in any one year, with the coloured area representing the likelihood of each risk profile generating annual returns within this range over 50% of the time. The blue vertical line represents the likelihood of generating annual returns within this range 90% of the time.
Continue to review and update
Overall, Lonsec’s 2020 review has resulted in relatively minor changes to the strategic asset allocation across our risk profiles. As previously noted, the reclassification of direct property and the removal of global small caps as a discrete allocation saw some reallocation of capital in the real assets and equities sectors. Because SAA is based on a forward-looking, long-term view, typically SAA weights do not change dramatically, and this is why Lonsec only reviews them every two years. However, the process is essential to achieving your objectives, and the success of your portfolio depends on getting SAA right. Even after you have set your long-term allocations, you still need to come back to them and rigorously test the assumptions you have made.
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