In the early 1950s, Harry Markowitz pioneered the development of a quantitative method that considers the diversification benefits of portfolio allocation. The principles of Modern Portfolio Theory changed the investment world forever and paved the way for the development of pooled funds, indexed-based funds, as well as exchange-traded funds. This style of asset allocation has since evolved into many permeations, which have all found places within the investment community.
The classic 60/40 balanced portfolio
Over the past few decades, asset allocators, balanced fund managers and risk parity adherents relied on bonds as the perfect complement to their equity holdings. Like the timeless pairing of the little black dress with the classic black pump, this was previously the ideal combo. However, the market has materially changed and peering into the crystal ball has become decidedly murkier. The enduring levels of fiscal and monetary stimulus during the current market environment have prompted an increasing search for alternative sources of return and questioning the continued viability of the neoclassical 60/40 balanced portfolio approach.
The effects of the COVID-19 pandemic ushered in a new era in March 2020, as asset classes sold off sharply globally and asset class correlations converged to 1. Local listed property was the hardest hit, plummeting 36.3% in March 2020, following a 15.7% decline in February 2020. The All-Share Index (ALSI) was down 12.1% and the MSCI World declined 1.5% in ZAR terms. Local bonds delivered a dismal negative 9.8%, inflation-linked bonds declined 17.5%, while preference shares lost 27.0%. Cash, on the other hand, was up 0.6%. Those who did not follow the playbook of the previous years and had a sizeable portion of their savings in cash would have felt smug as risk assets experienced these large drawdowns. Though those investors would have not participated in the turnaround as most asset classes ended 2020 on a positive note and extended these gains into the first half of 2021.
Asset class performance | Calendar year returns
Source: Morningstar Direct, Absa Multi Management
The challenge is that correlations between asset classes tend to increase in negative markets. Not only are valuations in some equity and bond markets currently at extremes, but outcomes may be binary. One consideration that has been topical is an allocation to alternative assets which may serve to mitigate long-only equity risk, a role traditionally held by bonds. Ultimately, getting the asset allocation decision right may well be the most important driver of relative performance in the short to medium term. Those that know how to adjust their game plan and find the right balance in the current market environment will come out as winners.
The importance of selecting the right line-up
South African multi-asset high equity funds have historically been the savings vehicle of choice for local investors. At the end of 2020, multi-asset high equity funds accounted for approximately 22% of all assets invested in local collective investment schemes, according to the Association for Savings and Investment South Africa (ASISA).
The chart below shows the cumulative returns of the largest 10 funds, which make up approximately 70% (over R450 billion) of the R650 billion invested in the ASISA South African multi-asset high equity category.
(ASISA) South African multi-asset high equity largest 10 funds | Five-year cumulative returns
Source: Morningstar Direct, Absa Multi Management
It is therefore reasonable to assume that most investors have exposure to these largest funds in one form or another in their portfolios. While these funds have managed to avoid the long tail of bottom quartile performance, it is, however, important to note the large dispersion in outcomes among these 10 largest multi-asset high equity funds, which is about an 80% dispersion between the highest and lowest performing fund on a cumulative basis over five years. Therefore, selecting the right blend of funds becomes crucial to diversifying your portfolio without introducing unintended risk.
Important to consider are the asset allocation challenges that have emerged from several secular changes that we are witnessing in capital markets. Whether inflation will surge long-term remains the key talking point, while the US Federal Reserve continues to deem it as transitory. Fund managers will need to manage the left-tail risk of high inflation, as well as find truly uncorrelated assets that provide reasonable inflation-adjusted returns. While the positive current account and reserves in South Africa continues to surprise on the upside, driving positive ZAR regime appreciation supports persistent lower inflation. Another talking point is whether commodity prices will be sustainable or collapse. Views vary as some commodity prices remain elevated, notably metals, which are well above their pre-pandemic levels while concerns around most of these markets going into oversupply in the medium term remains. Essentially, fund managers that have a clear view of the structural forces driving the market will have an edge when it comes to cutting through the noise and navigating short-term changes.
While all these considerations pose an asset allocation quandary, the best approach remains finding the right pieces to fit together to form the optimal diversified portfolio.
At Absa Multi Management, we believe skilful fund managers are those that have the ability to outperform over time. Our offerings are not only diversified, but also optimised. We select different strategies that we believe are required for specific market environments, including enhanced indexation and factor-based strategies, to diversify across risk premia and sources of returns that exhibit evidence of market reward despite temporary disruptions.