Most asset allocation processes thrust upon advisers now look at things the wrong way round, warns Graham Bentley, with profilers calculating a risk level in the absence of an investment objective
"Ships in a harbour are safe. But that's not what ships are built for…"
Admiral Grace Hopper
Investing is primarily about returns - mitigating our future deficiency needs and, if we are lucky, fulfilling some aspirations too. We forego spending now, in exchange for benefits in the future.
Asset allocation aims to deliver those required returns without undue risk - it is about efficient portfolio management. We have, however, created a set of conditions where the risk tail now wags the investment dog.
Most asset allocation processes thrust upon advisers are risk-focused - profilers calculate a risk level in the absence of an investment objective. Capacity for loss ignores the personal consequence of not achieving an objective.
The regulator and his minions overlook this pragmatism - the risk-reward coin has become double-headed, mirroring Keynes's contention that for reputation it is better to fail conventionally than succeed unconventionally.
The adoption of this reckless conservatism has been underpinned by ‘safe' assets delivering excess returns for little apparent risk - the ‘bond bonanza'. Since 1982, investors have experienced astonishing growth in bond prices, driven by a plummeting discount rate - that is, the sum of interest rates and inflation, which is the basis upon which potential investment returns are valued.
This so-called ‘Great Moderation' fostered the sultry weather conditions within which most managers and advisers have learned their trade. For most, this was and is ‘normal service'.
A US interest rate rise, along with a rise in UK inflation - albeit to a rather less-than-vertiginous 2.3% - has however indicated stormy weather to come. Conventional wisdom dictates that, as the discount rate starts to climb, the present value of a bond's income stream and capital return at maturity will fall. This has led some to abandon bonds to varying degrees, switching allegiance to literal alternatives in a continued quest to deliver excess returns for meagre risk.
The risk tail has forced some to capitulate completely. As an example, Old Mutual Wealth's platform asset allocation tool currently allocates 45% of a Risk level 5 portfolio to Cash, with no fixed income exposure whatsoever.
Conversely, Distribution Technology's allocation model recognises the differing sensitivities of sovereign, index-linked, corporate and high yield bonds, and offers a 35% bond exposure with zero weighting in cash at Risk 5. This lack of consensus despite the same risk level raises real questions about providers' respective allocation processes.
Other allocators are moving away from familiar fishing grounds, casting their nets in somewhat murkier waters. The Targeted Absolute Return sector has led the Investment Association's net sales table in nine of the last 12 months, despite the fact no asset allocation model has a suitable benchmark to represent this hotchpotch of alchemists who, on the evidence available have yet to lay their hands on the philosopher's stone.
Despite its promise of an investment ‘free lunch', the Targeted Absolute Return sector consistently has almost double the risk of the Strategic Bond sector, as measured by the ‘spread' between best and worst performers. The triumph of hope over experience, it seems.
The same could be said of gold. Our latter-day alchemists' on-off love affair with the yellow metal is excused by gold's legendary inflation-proofing characteristics. Legend should not, however, be confused with myth.
Sir Isaac Newton set the gold price in 1717, at £4.4sh.111/2 d per ounce. By 1794, the price remained unchanged, the dollar equivalent being just under $20. The price was static until 1933 when US President Roosevelt banned the private ownership of gold, and the following year forced all owners of gold to hand it to the US treasury in exchange for paper money.
This was the depression era's equivalent of quantitative easing, allowing the supply of paper dollars to increase, by owning the gold against which that money was secured. Gold was revalued at $34 an ounce, where it stayed until the early 1970s, when President Nixon unilaterally abandoned the Gold Standard, thus allowing both the dollar and gold prices to float.
We only have 40 years data on the behaviour of a free-floating gold price. On an inflation-adjusted basis, an ounce of gold today is worth less than it was in 1794. Hardly inflation-proofed, then.
As ships are designed to sail in tough conditions, a well-constructed investment portfolio can survive buffeting market conditions. Fleeing to an apparent investment safe haven ignores the fact that familiar assets in wiser, more experienced hands present opportunities that can counter both rising inflation and interest rate increases without exacerbating risk.
Index-linked bonds are an obvious example, but convertibles, floating-rate notes, junior debt of investment grade companies, fixed-to-floater perpetuals and so on present real diversification benefits with sensible return expectations.
The Investment Association's latest net sales figures suggest advisers are not entirely persuaded by the alchemists. The genuine safe haven remains a diversified multi-asset portfolio built for the long-term, and managed, with patience, to satisfy the aspirations of the investor rather than the fears of compliance.
Graham Bentley is managing director of investment consultancy gbi2. You can read more of his columns here
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