Remember the halcyon period prior to the global financial crisis (GFC), when nearly all asset classes showed strong returns and choosing the right investment manager made all the difference? With those days now a distant memory, asset allocation has become the crucial factor in generating outperformance, according to new research by AMP Capital.
During Australia’s long bull market run from 1982 to 2007, investment managers moved away from asset allocation to instead focus on individual manager selection at the asset class level. With an average return of 11.9 per cent a year from Australian diversified funds over this period, and the two main asset classes of bonds and shares moving together, it was a strategy that paid off handsomely.
However, in 2014 the world is still struggling to recover from the effects of the GFC, with the International Monetary Fund and other forecasters pointing to a sluggish global recovery. The impact on returns is marked, as indicated by AMP Capital’s projection of an average 7.5 to 8 per cent annual return from a diversified asset mix over the medium term.
With an end to double-digit returns and ongoing market volatility, asset allocation has made a comeback as the critical determinant of investment success, particularly for those who believe that active management adds no value.
Importance of asset allocation
Asset allocation’s importance is shown by its impact on the return generated by a fund. This comprises the fund’s long-term allocation to each market class and its market return (known as strategic asset allocation, or SAA); any deviations in the asset mix from the SAA, known as dynamic asset allocation (DAA); and the contribution from active management of the underlying asset portfolios, also called security selection.
Numerous studies have shown that asset allocation is the key driver of investment returns. But according to AMP Capital, this has become even more important in the post-GFC world:
·Returns will remain constrained, with expected lower yields on all asset classes, including bonds and shares;
·The range between top and poor performing asset classes will widen significantly, with those funds locked into high levels of the wrong assets expected to suffer consistently low returns;
·Volatility will remain high, with high debt levels in advanced economies and the end of quantitative easing in the United States impacting on emerging markets;
·Bond and shares will likely remain negatively or lowly correlated, unlike prior to the GFC.
For financial planners and wealth managers, asset allocation is now the new black. Ignore it, and you may be locking in long-term poor performance, at a high cost to investors.
For more information download AMP's free guide