AS UNCERTAINTIES rumble on across financial markets in 2014, it can be difficult for investors to look beyond short-term market dynamics when assessing risk and returns. Yet strategic asset allocation (SAA), an investor's long-term asset allocation with a five to seven year time horizon, is an integral aspect of overall portfolio returns. More than 80 per cent of the variation in the long-run value of a portfolio can be attributed to the SAA.
A SAA should typically match an investor's ability and willingness to take on risk with their return requirements. Bearing that in mind, and with the goal of cutting through today's headlines, what are the key considerations as we head further into 2014? There are five market issues driving the logic of our view: fixed income, alternatives, cash, commodities and foreign exchange.
THE GO-TO ASSET CLASS One of the natural go-to asset classes has been fixed income, with its historical reliability as a preserver of capital and source of return. Today, however, in an era where the bull market in bonds is seemingly at an end, the prospect of maintaining a traditional fixed income allocation is not particularly palatable to investors seeking a material yield. Returns in the government bond arena were negative in 2013, and are likely to be very low in the years ahead. Recent reporting of significant declines in fixed income trading across all the major global banks, from
Bonds may no longer do what they say on the tin, yet holding them within a diversified asset allocation has merit - especially in the event that equities decline, and as insurance against rising interest rates. To avoid suffering negative yields, investors should allocate larger proportions of fixed income exposure to US high yield corporate credit and short duration global investment grade corporate bonds.
NEW HORIZONS Alternative investments represent another potential area of diversification. Hedge funds are important for investors with limited cash flow requirements.
Illiquidity, opacity and cost have given hedge funds a poor reputation in recent years, particularly when their returns have been compared to equities or high yield corporate credit.
Entering an environment of lower returns across all financial assets puts this perspective into question. We expect hedge funds to deliver consistent annual returns of 4 to 6 per cent. With volatility similar to that of corporate bonds, they begin to look increasingly attractive.
THE UNDERPERFORMER Although cash is frequently viewed as the obvious solution for capital preservation, much like bonds, it is important to consider cash's expected performance in the context of an SAA. Over the long haul, it will typically underperform all financial assets that offer risk premia.
For example, if you invested a dollar in cash at the US Federal Reserve funds rate 30 years ago, today it would be worth around
We need only point to the Dow Jones UBS Commodity Total Return index, which is up by just 4 per cent in the past decade, to see little upside in commodity investment. Ample supply and more limited demand for the asset class present further risks. The outlook for crude oil, gold and base metals is not favourable.
HIGH VOLATILITY Questions of risk in relation to unhedged foreign exchange (FX) exposure are the final key consideration for the year ahead. In many ways, currencies are similar to commodities. Underlined by supply and demand factors, they do not offer a systematic risk premium to compensate for their volatility. The result is that investors may unwittingly be taking on extra risk when taking unhedged FX exposure.
While short-term dynamics cannot be ignored, we would strongly advise investors to assess their risk and return requirements from a longer term perspective. These five asset allocation strategies are just the place to start.
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