The Emperor’s new clothes? Changing fashions in investment strategies

The range of products available to investors has exploded over the last 50 years. Greater accessibility to different asset classes or instruments like commodities has played a part, but the rise of new strategies and vehicles has been the biggest factor.

Strategies differ from asset classes in that they represent an investment approach or system for creating a portfolio: a means of mixing asset classes rather than an asset class itself.

Strategies, like all investments, come in and out of favour. Investments were once limited to equities, bonds, or a mixture of the two. Now we have hedge funds, absolute return, risk parity, smart beta, diversified growth and other less well-known attempts at the holy grail of investing. But are these fads like the emperor’s new clothes: fashion without substance? Or is there something more than the investment industries’ desire to sell past returns?

A brief history of trends

The historic allocations of institutional investors, such as pension funds, reveals the changing landscape. Until the 1990s, pension funds generally held a mix of equity and bonds, the vast majority of which were from the UK. This mix varied but by the end of the 1980s, a ‘60/40’ mix (60% equity/ 40% bond) became increasingly popular and the norm for most multi asset portfolios.

A static 60/40 mix served investors very well. As the chart below shows, the returns to the strategy were not far off those from equity, while fixed income smoothed volatility and provided diversification in periods such as the market crash in 1987. There was very little need to try to adjust the mix in response to market moves.

1980s and 1990s


In fact, over the last thirty years there has been little difference in the returns between bonds and equities.

Little cost to diversifying through bonds


As a result, by the late 1990s, approaches which sought dynamically to adjust asset allocation were either seen as too difficult or irrelevant. It was more important to “generate alpha” –or select the specific outperforming securities within an asset class– than attempt to capture the right mix of asset classes over time. The background of the technology bubble heightened this trend and searching for specialist equity funds was seen as increasingly important.

After the market crash of 2001 priorities changed. Alpha wasn’t much help as equities as a whole declined in value. Investors generally looked to add alternative assets to provide growth for their portfolios –and by alternatives they meant assets that could make money when equities fell. Hedge funds and commodities rose to prominence as the 2000s progressed, becoming an important part of the portfolio for many institutional investors.

In 2008, however, it turned out that these alternatives weren’t that alternative at all. Many hedge funds and commodities did not provide the protection that investors had hoped for. Rather, it was fixed income assets –benefiting from the ongoing decline in inflation and low policy rates– that provided both diversification and strong returns ever since. US Treasuries delivered exactly the outcomes that many had originally wanted from hedge funds.

Rise of strategies partly driven by markets


Since then, the industry has moved on to other possible solutions like risk parity and diversified growth funds, which implicitly or explicitly emphasise their potential to deliver absolute returns – and by absolute return they tend to mean growth without the possibility of short term drawdown.

The importance of the regime

So, what investors want –and what the industry is happy to provide– is often conditioned by what has just been experienced in markets. Every time there has been turbulence in markets, the industry has looked for new solutions.

This suggests we should be sceptical of claims that the ‘latest thing’ will deliver absolute return across all regimes –and by regime we mean the economic and political characteristics of a period of time, for example, the inflation dynamic or the relative power between labour and capital. These are constantly shifting, so, is it really possible to generate absolute returns across multiple regimes?

Understanding strategies: the trade-off between diversification and growth

We argue that all strategies can be viewed as a balance between two groups: growth assets and diversifying assets.

‘Growth’ assets offer an income stream that can grow with inflation and will include equity and property (where rents and prices can increase in real terms). Assets that don’t offer this potential to match or beat inflation can be considered ‘diversifying’. These can deliver growth-like returns but only on the basis of price appreciation. Income streams will be fixed in the case of bonds, or even non-existent in the case of commodities.

Investors should be tactical in how they trade these diversifying assets, because unless they have a strong view on what their price will do, they are likely to give up some real return when adding them to a portfolio.

Most strategies reflect a time old principle


It is value that tells you whether to make this trade-off. At the end of the tech bubble, there was little cost to adding diversifying assets to a portfolio. In fact, over the shorter term, it was correct to be out of equities. Fixed income assets, on the other hand, have behaved like growth assets.

But there is no guarantee that this will continue. In fact, value signals suggest that the chances of it continuing look slim (see figure 5). Strategies that have delivered absolute returns in this regime seem unlikely to do so again unless they are built on a process which dynamically shifts between growth and diversification as regimes shift.

The cost of the trade-off over time


Diversified growth Funds

One of the latest investment strategies to gain popularity in recent years has been the ‘diversified growth fund,’ which has been forecast to attract assets of up to £200 billion by 2018. The name of ‘diversified growth’ fund, just like ‘hedge’ fund, is a label that encompasses a wide range of approaches. In both cases, they tend to have specific return aspirations (an actual return they seek to generate per year rather than an objective to beat a benchmark) and significant flexibility in what they can invest in and in what mix. These strategies offer the potential to deliver what they promise. But we must be clear on what exactly we are buying. If the emphasis is more on ‘diversification’ than ‘growth’, and this is a static feature of the strategy, then an investor needs to be clear on what function that is playing in their wider portfolio. A regime assessment and sense of valuation is central to this.

Conclusion: know what’s behind the label

What human beings want is an easy answer, a system to which they can delegate investment decisions and which removes the stress of uncertainty.

Unfortunately, while a ‘set and forget’ static portfolio mix may be possible over a very long time horizon, significant dislocations in valuation, inflation regime, and economic growth can last for decades or longer.

As a result, while new investment strategies like diversified growth have an important role to play for many investors, it is vital to understand the conditions which drive their success or failure. Only a truly active asset allocation approach, that seeks to shift between growth assets and diversifying assets when the price is right, can offer the potential for growth-like returns and a smoother ride overall in a range of environments.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.