Key Points:
- Strategic asset allocation is no longer the main driver of investment portfolio returns.
- The combination of near-zero interest rates, fiscal and monetary stimulus, and increased market access for retail investors has transformed the pricing mechanism.
- The growing importance of returns on private assets makes it harder to determine portfolio risk and returns using classical methods.
- The evolving environment, including regime changes, longer-term trends, and geopolitical factors, makes establishing a sound strategic asset allocation process difficult.
- Generating optimal returns in this new era requires a more integrated investment framework and new methods of assessing risk.
Strategic asset allocation has long been considered the primary driver of investment portfolio returns. However, the old adage that allocation determines 90% of performance is rapidly becoming outdated. In the current investing landscape, declining interest rates no longer drive beta performance, and there is increasing dispersion of returns within asset classes, regions, and sectors. This dispersion is further amplified by retail investors who now have greater access to the markets through zero-cost investment platforms.
Looking ahead, beta is expected to play a secondary role in performance generation as we enter an era of near-zero or rising interest rates. Three phenomena have emerged since early 2020, propelling the future of investing towards more precision-oriented strategies.
1. The Pricing Mechanism
The combination of near-zero interest rates, fiscal and monetary stimulus, and increased market access among retail investors has transformed the pricing mechanism. Price discovery seems to have been thrown out the window, as seen with examples like GameStop or AMC Theatres. Investors believe they will be able to sell quickly at a higher price due to excess liquidity and the expectation of finding a “bigger fool” buyer. Additionally, the use of options by retail investors has increased due to falling derivative transaction costs. This uncertainty in the pricing mechanism makes it difficult to set return expectations for various asset classes and decreases the utility of classical beta-oriented strategies.
2. Private Assets
Institutional investors have rapidly expanded into illiquid and non-public private market investments over the past decade. While this expansion offers benefits like diversifying income streams and expanding the investment opportunity set, it also presents challenges in determining portfolio risk and returns using classical methods. Valuation lag and supposed risk reduction benefits of non-market valued assets can lead to biases and lack of proper diversification within the asset class. However, there are targeted investment opportunities in private markets that are not found on listed exchanges, particularly in sectors that are ripe for disruption. Strategic asset allocation may not accommodate these targeted investment strategies, leaving return opportunities to smaller players.
3. Regime Change Everywhere
Last year’s developments, combined with policies instituted to counteract the impact of COVID-19 on the global economy, have accelerated the pace of transformation in the industry. Longer-term trends, such as changes in the way people work and the greater focus on environmental, social, and governance (ESG) factors, now influence short-term perception of investments. Governments across the globe have responded differently to the crisis, creating varying degrees of uncertainty. The evolving environment and accelerated pace of change make establishing a sound strategic asset allocation process and sticking to it particularly difficult.
To generate optimal returns in this new era, investment governance should deliver detailed investment decisions that are in sync with the times. This requires a more integrated investment framework and new methods of assessing risk. Sticking to the status quo will only sacrifice performance.
