Asset allocation is undergoing significant change. Aoifinn Devitt, chair of the Room151 LGPS Asset Allocation Forum, looks at what the future may hold.
What are the key challenges in asset allocation today? Today’s institutional investor is not only faced with the challenge of delivering a required return against a backdrop of strained valuations. They must also innovate, and rapidly so, as the investment industry automates and shifts shape at a rapid pace.
Just as the rampant spread of technology has brought obsolescence to many forms of hardware, what will the rapid pace of innovation mean for the investor’s tools of the trade? Is the reliance on traditional asset allocation and portfolio construction models the equivalent of turning up to a gun fight with the proverbial knife?
Tradition
Tradition would have it that the founding document and touchstone of institutional investing is the asset allocation decision, and it has long been touted as the most important decision that is made, besting manager and stock selection. But portfolio objectives have become much more complex than simply achieving a return.
For some funds negative cash flow is a reality and becoming more pronounced. Their asset allocation must also ensure regular cash flow. In order to do this a fund could pivot away from private equity, which tends to have a total return orientation and a less predictable distribution pattern, towards private credit, which can be structured to generate a regular yield.
A fund that needs regular income might seek more real estate or infrastructure exposure, to take advantage of the yield characteristics of these asset classes.
For all funds, asset allocation may also be required to fulfil a responsible investing aspiration. This may dictate a stricter scrutiny of the ESG (environmental, social and governance) credentials of the various components. There may be an interest in carbon neutral indices, or renewable energy infrastructure projects. Some funds may wish to divest from certain sectors, while all will be forced to engage in a collaborative fashion with the companies in which they invest. With the increased visibility of this area comes increased accountability, and an onus to show impact, not just effort.
We might also ask how well equipped traditional asset allocations are to cope with negative interest rates, deflation instead of inflation, and the growing wave of private debt?
Outcomes
One approach, in keeping with the disruptive forces at work elsewhere, is to upend asset class definitions in favour of the outcomes that we hope to achieve. Proponents of this approach would advocate for an outcome-based focus: using different buckets, such as income generation, inflation hedging or diversification, to fulfil a portfolio’s purpose. Other practitioners might prefer to explode asset categories into their component parts, or factors—such as value, size, momentum, quality, yield—and to construct a balanced portfolio in this way.
Traditionalists might maintain that asset classes are still the best, albeit imperfect, ways to categorise investments. This, at least, enables peer comparison with products that tend to self-identify under traditional labels.
However, this method, as well as the alternative methods suggested above, are essentially all “look-back” methods. Using average historic risk and reward characteristics is fraught with problems (“garbage in, garbage out”) but every way of slicing a portfolio is going to involve some historic factors (a historic characteristic of inflation protection, say, or a historic “quality” marker). Maybe the answer lies in blending these historic inputs with real-time data, to enable shorter feed-back loops and recalibration based on market experience.
Looking forward
But what about the recent innovations then, such as equity protection strategies? Can they future-proof a portfolio by avoiding certain pitfalls that took prior generations off-guard? Perhaps, but there is the danger that such innovations may be better suited to “fighting the last war” and, arguably, not the best solution for the next correction.
Instead of more “look back” strategies, I would hope that institutional investors and their advisers can be encouraged to “look forward” more. This would involve using an innovative mindset to question conventional beliefs about strategies and to hungrily consume as much new information that big data provides. Maybe pivoting towards a responsible investing focus can be a catalyst to do this, to question the sustainability of each investment, in a quest for ultimate future-proofing. Because, after all, the future is now.
Aoifinn Devitt is an independent investment adviser and chair of the Room151 LGPS Asset Allocation Forum on November 7.
