Maximising long-term returns using asset allocation

Even in economic good times, investing is a risky activity. Attempting to predict the future and bring together a combination of assets to fit that narrative is a trap to avoid. As recent geopolitical developments highlight, it’s exceptionally difficult to anticipate the evolution of world events, and after a steep fall in markets, it’s tempting to reduce risk by selling equities.

A better, more methodical approach is to estimate long-term returns by asset class and allocate the best mix of different investments to build a portfolio that maximises potential future returns for a given level of risk. As central banks abandon policies, such as quantitative easing, that have dampened market volatility in recent years, forming an educated opinion on future volatility and how the correlations between different asset classes are likely to evolve is a key part of this process.

Equities

For assets that benefit from economic growth – particularly equities – we utilise a combination of analysis of historical inflation-adjusted returns with:

• expectations of long-term economic growth
• inflation
• risk premia
• current valuation measures.

All this data helps us to draw conclusions about future returns; and the metrics substantiate our view that equities, over the next 10 years, should return 3-4% above inflation, somewhat less than we have seen since 2012.

Bonds

For defensive assets – principally bonds – we think carefully about:

• low starting yields
• the progressive unwinding of central bank quantitative easing
• future inflation-growth trade-off.

Our analysis of this information leads us to believe that bonds will struggle to match inflation over the next decade, and after 3 years of strong returns, we are starting to reduce the interest rate and credit sensitivity of our bond portfolio.

As a result, over the next decade, the inflation-adjusted return of a traditional balanced 60/40 equity bond portfolio is unlikely to exceed 2%, considerably lower than the returns recorded since 2012. So, while this long-term strategic approach to asset allocation removes the risk of short-term price volatility, prospective returns appear moderate at best.

Hybrid investments

A solution to increasing returns in a balanced portfolio is to include hybrid investments in the asset mix at the expense of traditional fixed income. At The People’s Pension, our default investment option invests almost 67% in equities, 20% in bonds, and the rest in real estate and infrastructure investments. These latter 2 asset classes have both equity and bond-like characteristics as they engage in the benefits of economic growth and pricing power while also producing income. Evidence also suggests that they can provide some protection against inflation.

Risk premia strategies

The equity assets we invest in also use risk premia strategies, which comprise:

• value
• momentum
• quality
• size
• low volatility.

Here, we employ a rules-based approach to benefit from market inefficiencies caused by investors’ various cognitive biases. We incorporate these strategies in a low-cost way within our members’ overall asset allocation.

The benefits of utilising hybrid assets and a risk premia approach

We estimate that introducing hybrid assets and a risk premia approach into our investment strategy should boost the long-term real return to around 3%, which, compared to a traditional balanced portfolio, is a better return. Obviously, there is no guarantee of future returns, and a combination of geopolitical uncertainty, elevated energy prices, and ongoing supply-side constraints is likely to lead to prolonged volatility, potentially whipsawing (ie the movement of stocks in a volatile market when a stock price will suddenly switch direction) those brave investors keen to trade markets tactically.

Looking forward

Looking to the future, after a weak start to the year, our base case is that economic growth will quicken as we move through 2022. However, inflation will remain a significant margin above the key central banks’ targets, and with wage growth lagging, real incomes will be squeezed. This time round, central banks will not be able to ‘look through’ unfavourable inflationary outcomes and there will be monetary policy tightening. Higher interest rates will be driven primarily by the authorities’ desire to ensure inflation expectations do not drift and cause a repeat of the 1970’s experience. Currently, financial markets are giving central banks the benefit of the doubt in their attempt to engineer a soft landing for inflation in 2023 while maintaining reasonable economic growth, and this remains our baseline scenario. Ifthis occurs, financial markets should recover lost ground as we head through this year. However, if central banks lose control of the inflationary narrative, expect further weakness in markets.