With asset allocation decisions reduced to a simple choice between risk-on and risk-off, Aviva Investors' Nick Samouilhan looks at how to approach portfolio construction.
Asset allocation is a complex interplay between strategic and tactical investment decisions. Although focused on different time frames, both types of decision involve favouring certain asset classes over others with the aim of managing risk and maximising potential returns.
The more options created by these two allocation processes, the greater the opportunity for outperformance. Unfortunately, however, the pronounced risk-on/risk-off behaviour now characterising markets is a direct challenge to this.
It dramatically reduces multiple asset allocation decisions to a simple choice between risk-on and risk-off asset classes, and subsequently increases the difficulty of correctly positioning a portfolio. Ultimately, it reduces the whole of the asset allocation process to a binary question: should investors overweight risk assets or not?
Why asset allocation calls have been reduced to one simple question
This approach can be highly limiting from a portfolio construction perspective. For example, take a look at the three month rolling correlation between returns from domestic equities (risk-on) and domestic bonds (risk-off).
The correlation between eurozone, US and UK equities versus German bunds, US treasuries and UK gilts respectively is more negative than in the past and moves in distinct episodic phases, which are aligned to periods of market panic and ebullience.
This situation is further aggravated by two other characteristics of recent market behaviour. Firstly, the nature of the new cycles we are seeing tends to be extremely short term, as well as inconsistent in length, with markets switching between risk-on and risk-off phases every month in no meaningful pattern.
Secondly, recent turning points have not been driven by economics or valuations, the standard drivers of markets, but rather by politics. Performance is driven not by stock selection or long-term positioning, but by whether managers find themselves correctly or incorrectly positioned for the current risk-on or risk-off phase.
These severe fluctuations have made fund selection a harder task for investors. Funds that find themselves at the top of the pile one month may then appear at the bottom the following month.
The ideal response to this environment is to continue focusing on long-term allocation and to ignore the lack of diversification benefits in the short-term.
This does not mean investors should forget short-term market movements completely but they do need to be careful of making rash decisions by withdrawing at an inopportune moment and jeopardising their overall financial objective.
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