Three top tips for asset allocation in a time of crisis

While the Great Financial Crisis may have carried greater overall risk to the financial system, this most recent crisis has one defining characteristic that makes it different to any other that we have seen in our lifetimes; a complete shutdown of the global economy. Now central banks have acted decisively in staving off a larger economic shock, but their actions will have consequences that last for decades to come. That’s why the decisions we make as allocators of capital now, will have outsized effects on portfolio outcomes in future. this is a crucial time in which to make good decisions.

Here, Quintin Price spells out three ways that family offices can navigate their portfolios through the times ahead.

1. Be on the right side of the inflation/deflation dynamic

There are plenty of big questions for investors to grapple with at the moment; will the dollar weaken? Will value equities finally outperform growth equities? Will emerging markets make good on their promise of being good value at the moment? But without doubt, the single most important question for the family wealth investor, is will what will happen to the levels of inflation. If you are on the wrong side of that dynamic, it will utterly undermine any other decisions that you make in portfolios.

This is a medium to long term question. The US Fed has pumped three trillion dollars’ worth of stimulus into the market place, with the promise of a further three to follow, an unprecedented level in peacetime. Now in the short term that has done the job of staving off a further economic shock, but given the scale of the economic shock already sustained, you would expect to see either deflation, or disinflation. But in the medium to long term you have to ask, where does that liquidity go? If it does lead to inflation, then portfolios need to be constructed to avoid the risk of negative real returns in fixed income. For investors who rely on fixed income as both a de-risking device, and a diversifier, a sustained low or zero rate environment with increasing inflation would be extremely damaging to returns. While those with greater exposure to commodities - particularly gold – selective real assets, and equities, would be in a stronger position to protect and grow capital. Right now, it is crucial to ask your portfolio managers what their views are on inflation, and how they are managing those risks.

2. Actively manage your benchmarks

Often, benchmarks are set at the outset of an endowment or family portfolio’s creation and then left static for decades. But for any individual or family concerned with long term wealth management, choosing your benchmark is one of the most important decisions that you will make. The reason for that is that it informs your asset allocation, and that is what informs around 80% to 90% of your returns. Investment decisions play an important part, but if US equities for example aren’t in your benchmark, then you can’t choose to invest those companies.

Even the most sophisticated endowments can spend a surprisingly small amount of time on this, but as the world changes, so too should your investment parameters. Ask yourself what is my benchmark and why did I choose it? And if you can articulate it, does that feel intuitively accurate? In the Great Financial Crisis of 2008 many endowments realised too late that they had far too much illiquidity risk because of overexposure to private equity – as determined by their benchmarks – so you have to make sure that you are setting out the right guidelines to inform your strategy, and accept that these may change as the world changes around you. Emerging markets for example have been cut out of many strategies after managers were burned by them in the past, but that doesn’t mean that they will always continue to struggle.

There are two rules to consider when thinking about benchmarks, the first is straightforward, and that is to diversify. It is the only free lunch in investing and can be enormously beneficial in a time of crisis. The second is more prosaic and is always underestimated, and that is that you must allocate according to the law of least regret. Rather than thinking only of outcomes, think about the risks that you have to take to get there, if choosing one sector or security over another leads to the same outcome but has been more volatile along the way, then you need to think carefully about why you took those risks in the first place. Your benchmark is the ultimate guide to how much risk you are willing to take in order to secure your target returns.

3. Look under the hood of your equity allocation

There is one major question facing equity investors right now - whether they know it or not – and that is; will value equities outperform growth? To put this in context, over the long-term smaller companies typically outperform larger companies, and value outperforms growth. Value meaning a stock that trades below its typical sector-based or intrinsic value, and growth being a stock that is growing revenues (note, not profit – many growth companies have yet to turn a profit). In the last two decades, these two rules have been reversed, a small number of giant, fast growing US tech companies have skyrocketed in value and dominated the market capitalisation of the S&P 500.

On the other end of the spectrum, cheaper companies are now as cheap relative to expensive companies, as we have ever seen. The extent of this distortion in price means that in statistical terms, it is a five standard deviation event; meaning that on the basis of history alone there is an infinitesimally small probability that growth will continue to outperform value. Those who favour growth will argue that we have undergone a paradigm shift, that the use of mobile phones and e-commerce means that it is fair to ascribe the lion’s share of future value to a small number of giant-cap companies. However, when the disparity in price between these two styles is very pronounced, you would have to have a strong constitution not to believe in the undervaluation of value equities. What this disparity also means, is that by simply holding an index ETF – say an S&P 500 ETF – you are making the decision, whether you know it or not, to back the predominance of growth equities. If you favour either value in style, or at least a more balanced approach between these two poles, then you need to be more selective.

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