Don’t Pigeonhole Investment Portfolios – Why Use A Multi-Asset Class Approach
A new book called “Multi-Asset Class Investing: A Practitioner’s Framework” is not exactly a made-for-Hollywood look at the investment business like “The Big Short.” However, it points out an industry practice that probably adversely affects more people than were hurt by derivatives traders during the housing crisis.
Most investment practitioners are highly compartmentalized, managing one, narrowly-defined type of asset. Investors may own multiple asset classes, but their investment policies tend to dictate that the asset mix be held within tightly defined targets. As the book highlights, this pigeonholed approach to investing misses where the real opportunities to add value and manage risk come from. The main point is asset allocation is always important.
Here are five reasons why taking a multi-asset class approach might be more relevant than ever in today’s financial markets:
1. Conditions are ripe for multi-asset strategies
One of the book’s authors, Pranay Gupta, makes the point that passive asset allocation is ill-suited for an environment in which the correlation between asset class returns has increased. For example, when stocks and bonds behave differently, you can reduce risk by splitting a portfolio between the two. However, if asset classes are going up and down at the same time, passive diversification is not a sufficient method of risk management.
Gupta also points out that customized financial instruments have blurred the lines between traditional asset classes. The availability of such hybrid products calls for something of a hybrid investment approach rather than a narrow, asset-class based perspective.
2. Unconventional asset behavior calls for active allocation
It is not just that stock and bond returns are more correlated than they used to be. The other challenge is that returns are running well below historical norms.
Already, the 21st century has seen two major collapses in stocks: the burst of the dot-com bubble, and the 2008 financial crisis. While stocks have struggled, abnormally low bond yields make them a less attractive alternative. Even the longest-term Treasury bonds are yielding well under 3 percent.
The point here is not just that returns have been disappointing. The other challenge from an asset allocation standpoint is that they have been behaving differently from historical returns. Passive asset allocation models are generally based on assumptions about asset class behavior based on those historical returns. When that history ceases to be indicative of how these assets are performing, it’s time for a different approach.
3. The investment industry has allocation upside down
Higher asset class correlations and low returns seem to create an especially urgent need for more focus on asset allocation now, but you could argue that the investment industry has been misguided in its approach all along.
Because the industry is largely organized into asset-class specialist managers or index funds, most of the industry’s focus is on managing within an asset class rather than on coordinating among asset classes.
Gupta refers to studies that have shown that roughly 80 percent of a portfolio’s risk and return comes from asset allocation, and only about 20 percent comes from individual security selection. In terms of how professional investors spend their time though, the industry has those proportions upside down. He estimates that 80 percent are individual security selectors, and only about 20 percent are engaged in asset allocation.
4. Too much attention is given to stock-picking
Even if you are not an industry insider like Gupta, you can get a sense that the focus is on minutia rather than the big picture. If you watch coverage of the stock market, most of it is focused on hot tips and the day’s big individual movers. When was the last time you saw one of those market gurus waving his hands about an asset allocation opportunity?
Think about it. A diversified portfolio might have 2 percent invested in a single stock. If that stock rises by 30 percent – a pretty healthy return – it will make 0.6 percent difference on the overall portfolio. Stock picking should not be ignored, but it does seem overrated.
5. Lack of flexibility takes away alternatives
Suppose you happen to be an ace stock-picker, and all your expertise and research tells you the stock market is overvalued?
An investment manager with a narrow stock mandate has no discretion to switch out of stocks under those circumstances. This is like putting someone at the helm of an ocean liner, but giving them no way of steering away from the icebergs.
Investment managers who take a fully-integrated approach to multi-asset class investing are harder to find, but they may be exactly what investors need to escape the disappointing results of pigeonholed portfolios.
Comment: How do you approach investment and asset class strategies for your portfolio?
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