T. Rowe Price T. Rowe Price Trusty Logo

Three Concerns Facing Asset Allocation Committees

Yoram Lustig, CFA, Head of Multi-Asset Solutions, EMEA
Andrew Armstrong, Solutions Analyst

Executive Summary

  • The lack of consensus on when the next economic slowdown will arrive poses a challenge for asset allocation committees.
  • Further complicating their task is the fact that a number of long‑standing assumptions about asset allocation are proving to be less reliable than in the past.
  • Asset allocators seeking to position their portfolios for a potential downturn may benefit from adopting a different approach based on active country and sector allocation and duration management.

The prevailing view is that the global economy is in the late stage of its economic cycle and a recession might be on its way. However, there is no consensus on when the slowdown will arrive. This presents a challenge for asset allocation committees, which are faced with the unenviable task of positioning their portfolios for an eventual downturn while simultaneously ensuring they do not completely miss out on any market gains that occur in the meantime.

Further complicating their task is the fact that several long‑standing assumptions about asset allocation are proving to be less reliable than in the past. Old habits die hard, and it can be tempting to fall back on tried‑and‑trusted methods when faced with difficult challenges. However, in order to effectively position their portfolios for the period ahead, it may be time for investors to reconsider some of their core beliefs about asset allocation. Below, we identify three key current concerns with traditional approaches to asset allocation.

1. Average Correlations Are Not Very Informative

It is common for asset allocators to have used historic average correlation figures when seeking to predict how different elements of their portfolio will perform in relation to each other. However, the evidence suggests that correlations change substantially in the left and right “tails” of performance distribution—i.e., when equity markets are performing either very well or very poorly. Generally speaking, the rule of thumb seems to be that when it would be useful for correlations to be positive (i.e., when equities are performing very well), they are often negative, and when it would be useful for the correlation to be negative (i.e., when equities are performing very poorly), it is often positive.

Opening Quote ...when it would be useful for correlations to be positive, they are often negative, and when it would be useful for the correlation to be negative, it is often positive. Closing Quote
Yoram Lustig Head of Multi-Asset Solutions, EMEA

To be more precise, it seems that the key determinant of whether correlations are positive or negative at any given period is whether the dominant influence on the market at that time is the economic cycle or monetary policy. When the economic cycle is the dominant factor on markets, the relationship tends to be negative: heading into a recession, equity prices tend to fall while bond prices rise; heading out of a recession, equity prices tend to rise while bond prices fall. However, there are periods when asset prices are impacted more by factors such as inflation and central bank actions than by the economic cycle. During such times, equity and bond prices tend to be positively correlated—falling in tandem during periods of high inflation, for example, and rising together when central banks are expected to ease policy.

Given this, it is easy to see why using average correlation figures will be ineffective in certain circumstances and that a better approach may be to gain a deeper understanding of how correlations shift over time and adjust portfolios accordingly. If you believe, for example, that recession concerns will weigh on asset prices, you may choose to be overweight bonds and underweight equities. If, however, you believe that the main influence on prices will be central bank rate hikes, you may decide to reduce your allocations to both asset classes. Developing a more sophisticated approach that factors in how correlations can shift will be much more complicated than using simple average correlation figures, but it is likely to be worth it in the long run.
 

Opening Quote ...a better approach may be to gain a deeper understanding of how correlations shift over time and adjust portfolios accordingly. Closing Quote
Yoram Lustig Head of Multi-Asset Solutions, EMEA

The Advantage of In-House Research

One of the advantages of working at a company like T. Rowe Price is that we can draw on the excellent research being conducted within the company. For this article, for example, we were influenced by the work of our colleague Sébastien Page, head of Multi‑Asset and chair of the Asset Allocation Committee. His 2018 paper When Diversification Fails delves into the vexing problem of how diversification seems to disappear just when investors need it the most. One of Sébastien’s main arguments—that many investors still do not fully appreciate the impact of extreme correlations on portfolio efficiency—helped to shape our thinking in this article.
 

2. The Problem With Building Portfolios Using Labels (Rather Than Drivers)

Traditionally, multi‑asset investors divided assets into three broad categories: equities, fixed income, and alternatives. Over time, however, a number of additional labels emerged within each category: In equities, separate labels arose for different countries and regions; fixed income became divided into sovereign debt and investment‑grade, high yield debt, and emerging market local currency debt; and alternatives bifurcated between hedge funds and property funds. However, some of the new categories within fixed income—for example, high yield debt and emerging market debt—are more correlated to equities than to government bonds.

This creates difficulties because if assets that behave more like equities are included within bond allocations, overall portfolio performance will be skewed. For example, if an investment manager who claims to be running a traditional 60/40 portfolio is invested heavily in high yield debt and is therefore effectively running a portfolio with much more than 60% equity risk, they will likely outperform other managers when equities are rallying but underperform when equity markets slump.

To avoid this, it may be necessary to move away from the traditional labels of equities, bonds, and alternatives and adopt new labels that focus on how assets behave—for example, “growth,” “defensive,” and “uncorrelated” (see Fig. 1). Growth assets are likely to include Japanese, European, and U.S. equities and high yield bonds and local currency emerging market debt; defensive assets would typically include core government bonds and investment‑grade bonds; and uncorrelated assets would include equity long/short and other hedge fund strategies.

(Fig. 1) Traditional Labels Do Not Work
Focusing on asset behavior provides more insight


Source: T. Rowe Price.
 

3. Fixed Income Might Not Be What You Think It Is

The final challenge for asset allocators is that even traditional fixed income assets such as sovereign bonds may no longer perform as they have done in the past. Historically, developed market sovereign bonds have generated fairly low overall returns while maintaining low duration (price sensitivity to changes in interest rates), meaning they have been far less volatile than equities and equity‑like assets. More recently, however, yields have collapsed at the same time as duration has increased. If the performance of sovereign bonds were replayed over the past 30 years using present‑day levels of yield and duration, the asset class would have been 30% to 40% more volatile.

When duration was low, a 5% change in yield would have only a limited impact on the value of the bond. Now, because duration is much higher, a similar change in yield would have a much bigger impact on the price. What this means is that sovereign bonds are far riskier than they were in the past—however, this won’t be visible in simple models that do not reflect the current much higher levels of duration.

Opening Quote ...sovereign bonds are far riskier than they were in the past—however, this won’t be visible in simple models that do not reflect the current much higher levels of duration. Closing Quote
Yoram Lustig Head of Multi-Asset Solutions, EMEA

Adopting a More Sophisticated Approach

Asset allocators seeking to position their portfolios for a potential downturn in the global economy may benefit from abandoning some of their traditional assumptions and adopting a different approach based on active country and sector allocation and duration management. Times like the present, when countries across the world are at very different stages of their interest rate cycles, provide a good opportunity to build portfolios that are diversified across countries and markets, comprising assets with low correlations to each other. We believe this approach may be the most effective way of navigating what could be a volatile period ahead.


Important Information

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request. It is not intended for distribution to retail investors in any jurisdiction.

 

201908‑933812

Dismiss
Tap to dismiss

Download

Latest Date Range
Audience for the document: Share Class: Language of the document:
Download Cancel

Download

Share Class: Language of the document:
Download Cancel
Sign in to manage subscriptions for products, insights and email updates.
Continue with sign in?
To complete sign in and be redirected to your registered country, please select continue. Select cancel to remain on the current site.
Continue Cancel
Once registered, you'll be able to start subscribing.

Change Details

If you need to change your email address please contact us.
Subscriptions
OK
You are ready to start subscribing.
Get started by going to our products or insights section to follow what you're interested in.

Products Insights

GIPS® Information

T. Rowe Price ("TRP") claims compliance with the Global Investment Performance Standards (GIPS®). TRP has been independently verified for the twenty one- year period ended June 30, 2017 by KPMG LLP. The verification report is available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm's policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation.

TRP is a U.S. investment management firm with various investment advisers registered with the U.S. Securities and Exchange Commission, the U.K. Financial Conduct Authority, and other regulatory bodies in various countries and holds itself out as such to potential clients for GIPS purposes. TRP further defines itself under GIPS as a discretionary investment manager providing services primarily to institutional clients with regard to various mandates, which include U.S, international, and global strategies but excluding the services of the Private Asset Management group.

A complete list and description of all of the Firm's composites and/or a presentation that adheres to the GIPS® standards are available upon request. Additional information regarding the firm's policies and procedures for calculating and reporting performance results is available upon request

Other Literature

You have successfully subscribed.

Notify me by email when
regular data and commentary is available
exceptional commentary is available
new articles become available

Thank you for your continued interest