Investors who believe that asset allocation is the most important consideration in their portfolio’s construction are possibly making a mistake. This is according to David Crosoer (pictured), executive of research and investments at PPS Investments.
Asset allocation is a technique used to spread your investment across several asset categories. However, Crosoer believes that manager selection will be the crucial differentiator of future performance.
“For at least 20 years the investment community has held on to the idea that asset allocation (rather than manager selection) is the most important decision to get right in generating long-term returns for clients. Another commonly-held belief is that most of an investor’s performance is determined by the extent to which he or she is willing to hold equities over other asset classes. The investment community even coined a term, “equity risk premium”, to describe the additional return investors should receive for holding “volatile” assets like equities over “safer” assets like government bonds,” said Crosoer.
How have South African equities performed?
Crosoer said South African equities have bucked the trend and compounded at over 8% real (after inflation) over a similar 25-year period but this is unlikely to continue. Crosoer argues that passive equity exposure, which involves strategies that attempt to mimic the return on the market rather than selecting securities that will perform better than the average, does well when markets are inexpensive or global growth improves.
“We believe that our equity market, like global markets over the past 25 years, is unlikely to deliver real returns significantly greater than 4% a year - after inflation. In such an environment, a passive exposure to equity markets is unlikely to deliver inflation-beating returns of the magnitude that most clients will need. Rather, the crucial determinant of performance will be the actual stocks your managers choose to hold. As a result, we believe that for the next decade manager selection rather than asset allocation may be the most important thing for investors to get right,” said Crosoer.
So does asset allocation still have clout?
Mark Thompson, CEO and founder of Southern Charter, said the asset allocation process that Southern Charter has implemented since the company’s inception, allowed funds to achieve market-beating performance in very difficult conditions.
“An asset allocation strategy involves allocating the assets on a predetermined basis. For example, the long term allocation to achieve a growth rate of inflation plus five percent might be 35% equities, 55% bonds and 10% property. How these percentages are determined, is based on long term capital market assumptions and the funds long term risk tolerance levels. It is this philosophy that enabled us to defend our clients’ money through the worst of the financial crisis,” he said.
Play it safe with a diverse portfolio
According to Thompson, diversification is the key to spreading one’s risk. “Even if equity is delivering very attractive returns, remaining 100% in equity, does not make sense. It’s important to balance your investments with your risk profile,” he said.