It’s good to be different: Instead of outsourcing to a peer-group benchmark or a third-party asset allocation provider we design our framework in-house
In the 1968 Summer Olympics Dick Fosbury shocked spectators with his unique approach to the high jump. Before Fosbury, high jumpers would use traditional methods to clear the bar. However, Fosbury revolutionised the event by jumping over backwards, giving him more momentum and potential for height. Over the next few years, the ‘Fosbury Flop’ became the dominant style of the event and remains so today. Fosbury was a pioneer and it was his unique approach that helped him secure his Olympic gold medal.
Like Dick Fosbury, we think it’s good to be different. Rather than following the crowd by outsourcing our asset allocation framework to a peer-group benchmark or a third-party provider, we design it in-house. By doing this we can create an asset allocation framework built on a more comprehensive set of methodologies than the average multi-asset solution.
Raising the bar
Take peer-groups for example. One constraint is that they need to hold assets in minimum proportions to stay within the peer-group, even though they might not want to hold that asset at all. Secondly, they sometimes engender a herd-like mentality towards increased risk in the attempt to achieve better returns and a higher quartile ranking.
Third-party asset allocation models are not without their limitations either. They usually have a bias to UK assets, such as UK equities and gilts, despite empirical evidence suggesting that a global approach is more efficient over the long term.
Here are three ways in which we look to raise the bar.
1) Taking a global view – because we take diversification seriously
Our starting point is a global asset allocation model to create a truly diversified portfolio, free from a potentially unwarranted home bias. A global approach should achieve a better risk-adjusted return over the longer term than a portfolio that is too concentrated in any one region. In addition, a global approach allows for exposure to interesting sectors, such as US and emerging market equities, which generally offer better returns than other regions, on a risk-adjusted basis.
2) Using forward looking measures – because history doesn’t always repeat itself
Many traditional asset allocation models rely heavily on historical data. Instead, we use a combination of historical data and proprietary expected return projections. By using our forward-looking measures, we can incorporate recent market trends and forecasts. From there we can develop a framework which is relevant to the current market conditions we find ourselves in today, as opposed to just a long term historical average.
3) Protecting against tail risk – because volatility doesn’t tell the full story
Volatility is a useful measure of risk, but it has significant limitations. Volatility measures show variations around the mean – in other words, a high level of volatility will show large moves in the value of the asset from one day to the next and low volatility will show small moves. However, volatility doesn’t capture how much money an investor could lose in a tail risk event like the global financial crisis.
By incorporating tail risk into our analysis, we can glean a better understanding of the driving factors of risk and return. For example, Japanese equity historically has been more volatile than UK and US equities; however, on a tail risk basis Japanese equity stacks up quite well, due to the defensive nature of the Japanese yen.
Just like Dick Fosbury, it’s good to challenge the status quo and find ways to improve on standard conventions. Ultimately, a strong asset allocation framework should be one that is global, diversified and dynamic. By moving away from traditional asset allocation models, we can take a broader and more active view to help us improve risk-adjusted returns for clients.