Strategic asset allocation, the hallmark investment approach of financial advisory firms who use risk profiling to determine a client’s investment portfolios, is under the spotlight, with an increasing number of investment firms questioning whether the strategy remains appropriate in light of the seismic shift seen in financial markets over the past decade.
The 2007-2008 global financial crisis led to historically low interest rates and huge monetary stimulus around the world that have successfully inflated asset prices. However, these same forces now mean that returns on cash and bonds are likely to be much lower for longer, meaning those allocations in a portfolio are not going to provide much by way of returns going forward. Furthermore, many traditional models of pricing equities and property now expect exceptionally low, or even negative, returns over the next decade should market valuations mean revert at any stage.
The re-emergence of some positive correlation between bonds and equities, not seen since the late 1990s, has also left SAA portfolios vulnerable to any increase in inflation or real interest rates. This year’s pandemic-related market downturn has further entrenched these trends.
A popular strategic asset allocation of 60% equity to 40% bonds – commonly known as a ‘balanced’ allocation – has historically provided gains given it has been highly suitable for what has happened. However, the recent market upheaval has left many investors sitting on disappointing returns. Most importantly, the outlook for future returns looks far more challenging, and will ultimately force many financial advice firms to rethink their investment strategy when it comes to helping their clients to achieve their retirement lifestyle plans. Firms that are more proactive in this regard, stand to benefit the most.
Due to higher valuations, and limited future diversification, continuing to passively invest client funds using the conventional strategic asset allocation approach has become a significant business risk for clients, and therefore advice firms. If an advice firm cannot provide sufficient investment returns or properly manage large downside risks to markets, they face losing clients. This situation could be compounded by lower profits if the firm’s revenue is linked to subdued growth in funds under management. Compounding these concerns is the increasing regulatory risk should it be concluded that the SAA investment approach is not fit for purpose and failed to improve the client’s financial well-being in line with their stated goals.
Astute advisers that are concerned about the outlook of traditional investment portfolio construction are considering their alternatives, including employing active asset management with broad and flexible asset class ranges within a goals based investment strategy. Goals based investing aims to invest into whichever markets best meet each client’s unique financial objectives rather than invest in pre-determined and inflexible strategic asset allocation ranges. Furthermore, it has a focus on limiting downside risks and avoiding permanent loss of capital, all while generating returns in different market conditions than what SAA is capable of achieving.
Goals based investing dynamically allocates invested capital to markets with the best prospective returns or that are less correlated with others and traditional assets, in order to ensure portfolios are truly diversified. Its flexibility to adapt the investment strategy in response to market shifts provides an improved likelihood of being able to generate returns without taking on excessive risk in challenged market conditions and is better suited for volatile market conditions and a changing world order. Portfolios can include selective increased use of non-market dependent investment strategies such as long-short and market neutral strategies, as well as exposure to a broader asset pool including commodities and currencies, which behave very differently to interest rate sensitive equities and bonds.
If you’re interested in partnering with a professional investment manager that can provide true diversification via a dynamically managed multi-asset strategy to ensure your clients meet their financial goals and your business continues to prosper, contact Dynamic Asset today.