Rethinking asset allocation

“There’s a realization that equities are very highly correlated across markets, that you basically have the same underlying risk factors whether you’re investing in Canada, the U.S., Europe, Australia, etc., and that you should spend some of your resources on some of the other buckets, like fixed income and alternatives.”

Another trend sees more attention paid to underlying risk drivers across asset classes. Instead of drawing hard lines between asset classes, the idea is “to say, there’s an equity component of the portfolio, but within alternatives I’m also invested in private equity. Private and public equity are basically the same thing, so in the long run you will expect to get a very similar risk premium—maybe a little more from private equity for any number of reasons, but correlation-wise and risk-wise, private equity and public equity over longer horizons will look very similar,” Nielsen said.

On the fixed income side, high yield and corporate bonds have a very different profile from government bonds. Corporate bonds may be highly correlated to the underlying equity, so in the event of a recession, not only will the equity suffer, but the corporate bonds will suffer as well.

“If you look at the underlying risk factors you will see that these corporate bonds actually have a lot of equity-like risk.” Treating them separately does not, therefore, make much sense at all, in Nielsen’s view.

He also suggests ‘alternative investments,’ as an asset class, is a misnomer.

“It’s too broad. You have hedge funds, and within hedge funds there are so many different strategies with so many different return and risk profiles. There’s timber, infrastructure, real estate and all kinds of other assets, and you have no clue what category to put them in, so you just call it alternatives. You then end up with a bucket that’s full of hopefully unrelated investments.”

But that doesn’t necessarily mean they’re unrelated to other assets in the portfolio, Nielsen says. Many of these alternatives will be highly correlated to the portfolio’s fixed income or public equity investments.

“By artificially dumping them into this new bucket called ‘alternatives’ without understanding how this bucket is related to the rest of your portfolio, you very likely end up with situations, as many did in 2008, where you suddenly realize all these alternatives were actually not alternatives, but looked very much like the rest of the portfolio—except they were leveraged up and caused even more trouble on the performance side.”

Nielsen says investors interested in alternatives need to “look under the hood” to understand the risk profile of each individual investment. “This will lead to a more objective selection of the individual parts of your alternative strategy.”

Another trend Neilson touched on was tactical asset allocation, which involves temporarily deviating from the portfolio’s long-term or strategic percentage weighting of the various asset classes with a view to capitalizing on opportunities that open up in the market.

He notes that those who went into equities right after the meltdown in late 2008 and early 2009 made a very good decision, illustrating how important the entry point really is.

“Everybody was afraid the world was coming to an end, so very few were willing to add risk on top of the big losses they just recorded. If you’re good at tactical asset allocation there’s an enormous potential to add value. But I think the jury is out on whether there are any consistently good players out there.”

Watch for Tactical Asset Allocation: What It Is, How It’s Done, coming in the August edition of Advisor’s Edge Report.