INTRODUCTION
Whether your goal as an investor is capital growth, income generation, or simply inflation protection, it all comes back to the same equation: attractive returns with minimal risk of losing your capital. Investing today is much more challenging than it used to be 20 years ago. In 2000, investment in U.S. government debt generated a 5% return with little or no risk. Simply put, you needed $2 million in capital to generate $100,000 in annual income. Today, to obtain the same result, you need $3.6 million in capital.
The direct consequence of this was that investors turned to riskier and more complicated investments in search of higher returns. But as the complexity of investments grows, so does the need for highly skilled managers to mitigate and diversify the additional risk taken.
In that philosophy, multi-asset funds offer an efficient solution to the challenging conditions in today’s investment world. Empirical studies have shown that the success of multi-asset strategies lies in 4 basic pillars.
PILLAR 1: INVESTMENT VERSUS CASH
Over the medium to long term (5 to 10 years), all asset classes have historically generated real returns, which means they are above inflation (see Figure 1 below). Don’t forget that by sitting on cash, you are not adopting a conservative strategy; you are only condemning your capital to lose purchasing power day after day due to inflation. Investing, of course, is not risk-free, but it is a much wiser alternative where risks can be managed.
The most feared risk of investing is buying at the top, just before the markets experience a slowdown. One way to mitigate this risk is to invest over a long enough time horizon so that even if you enter the top, the annualized return remains positive. The other great tool for investors to protect themselves from market movements (market timing) is diversification; we will address this issue in our third pillar of basic investment principles.
One of the advantages of investing is the capitalization effect. By investing and maintaining the investment, you are not only accumulating earnings year after year, as you would by keeping your savings under a mattress each year; you are allowing your earnings to be automatically reinvested to generate “earnings on earnings”. This combination effect is what allows your portfolio to grow exponentially as illustrated in Figure 2
PILLAR 2: ASSET ALLOCATION DRIVES PORTFOLIO PERFORMANCE AND RISK
In 1986, Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebowe published their landmark study, “Determinants of Portfolio Performance. The goal was to find out what drives portfolio performance and risk. Their findings have been confirmed by countless additional research materials and are still used by today’s largest and most important investors. Their conclusion was that a portfolio’s strategic asset allocation is responsible for the vast majority of returns and risks. (see figure 3)
What this essentially means is that spending time analyzing whether General Motors’ stock will perform better than Ford’s is not an efficient way to spend your time, nor is trying to guess when the market will rise again. What really matters is choosing the right asset classes to invest in and in what proportions.
In Graph 4, we can see the annual rated performance of each asset class, and what we can immediately perceive from that representation is that the winners and losers are very different from year to year.
Strategic asset allocation is just that; try to invest in the best performers and avoid outliers. While not easy, it is a much more productive use of time and resources than focusing on stock selection and market timing. As a result, if a multi-asset fund manager is to be successful over the long term, most of his efforts must be devoted to asset allocation.
Figure 4: Annual Performance Rankings by Asset Class (January 1994-December 2016)
PILLAR 3: MODERN PORTFOLIO THEORY
The third pillar is again evidenced by empirical information and is probably the oldest rule in the investment world: diversifying a portfolio of asset classes reduces risk and increases returns.
PILLAR 2: ASSET ALLOCATION DRIVES PORTFOLIO PERFORMANCE AND RISK
In 1986, Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebowe published their landmark study, “Determinants of Portfolio Performance. The goal was to find out what drives portfolio performance and risk. Their findings have been confirmed by countless additional research materials and are still used by today’s largest and most important investors. Their conclusion was that a portfolio’s strategic asset allocation is responsible for the vast majority of returns and risks. (see figure 3)
What this essentially means is that spending time analyzing whether General Motors’ stock will perform better than Ford’s is not an efficient way to spend your time, nor is trying to guess when the market will rise again. What really matters is choosing the right asset classes to invest in and in what proportions.
In Graph 4, we can see the annual rated performance of each asset class, and what we can immediately perceive from that representation is that the winners and losers are very different from year to year.
Strategic asset allocation is just that; try to invest in the best performers and avoid outliers. While not easy, it is a much more productive use of time and resources than focusing on stock selection and market timing. As a result, if a multi-asset fund manager is to be successful over the long term, most of his efforts must be devoted to asset allocation.
Figure 4: Annual Performance Rankings by Asset Class (January 1994-December 2016)
PILLAR 3: MODERN PORTFOLIO THEORY
The third pillar is again evidenced by empirical information and is probably the oldest rule in the investment world: diversifying a portfolio of asset classes reduces risk and increases risk-adjusted return.
Figure 5 shows the effects of diversification on yield and volatility. It not only reduces volatility but also improves returns.
A diversification strategy can help to achieve more consistent returns over time and reduce overall investment risk. It is key to any long-term investment strategy.
PILLAR 4: PREFER PASSIVE INSTRUMENTS TO TRADITIONAL ASSET CLASSES
For traditional asset classes, investment in low-cost indices is likely to outperform most actively managed investments and the likelihood of superior returns increases over time (see Figure 6). In fact, the emergence of Exchange Traded Funds has offered a significantly enhanced tool for investing in traditional assets commonly known as stocks and bonds.
These are just some of the advantages of investing in indices:
– Index investment offers greater transparency and lower costs in relation to active management and now represents a market of USD 6 trillion worldwide
– Index replication investments provide an efficient method of implementing an asset allocation.
– Index investments tend to outperform actively managed funds over the long term due to the higher costs of active management and the difficulty of predicting future stock prices.
Figure 6: Percentage of active funds that did not outperform their indexes.
CONCLUDING REMARKS
The diversified, strategic and low-cost nature of multi-asset funds makes them a suitable base instrument within your overall portfolio. By combining asset classes that do not rise and fall at the same time, investment risk is reduced and investment returns are increased. Quality multi-asset funds are a great tool to use as a base upon which to add other investment vehicles and opportunities. In today’s market, investing by proxy is a dangerous task, so be smart and make sure that your capital is invested according to the 4 basic pillars. What better way to do this than by using a multi-asset fund?
For more information, Contact Us:
Romain Dromard
Chief Investment Office – Managing Partner
To learn more, contact us at:
info@kb-familyoffice.com
April, 2018
