ASSET CLASS INVESTING

A key message that has been uncovered through decades of academic study in the field of finance is that superior returns are achieved not in trying to ‘beat’ the market, but in letting the market work for you.

This is a fundamentally different approach from traditional stock picking or the ‘active fund management’ industry that rely on a forecast in an attempt to choose the best investments for anticipated market changes.  There is little evidence of individuals or professional money managers consistently succeeding in this endeavour. 

Whilst a fund that tracks a market index will reliably outperform actively managed funds over the long term, there are enhanced strategies that take this several steps further.  A portfolio comprising a core allocation to structured asset classes will harness the best aspects of passive management without the inefficiencies of some index strategies. 

Asset Class investing utilises advanced portfolio engineering that is founded on the evidence that targeted exposure to relevant market dimensions will deliver the highest returns over time.

GROWTH and Income

 The case for equity investing is strong.  Over time, the equity premium delivers returns in excess of less volatile asset classes.  However, the inevitable short term fluctuation in asset values is the price an investor must pay when seeking the rewards of the growth strategies indicated on the steeper trend lines on the graph below. 

The smoother lines of cash and bonds are defensive in terms of market volatility and may derive steady cash flow, but are less effective as a hedge against inflation.  Combining growth and defensive assets in a portfolio taking account of individual client risk tolerance and investment objectives will provide the strongest base for long term income requirements.

Growth of US$1: 1926 to 2013

RISK & RETURN ARE RELATED

We find ourselves frequently talking to clients about the risk and return trade-off. Investors understandably focus more on the reward part of the equation when markets have enjoyed a period of buoyant returns.  Conversely, when negative sentiment is prevalent in the news media clients can feel more risk averse.

Fortunately scientific resources are available to understand the influences of risk and return on markets and investor behaviour. 

Academic studies have determined that risk factors of market size and book-to-market ratios seem to account for virtually all the differences in returns across shares — not industry groups or other sectors.  Assembling portfolio elements along these dimensions of returns can guide us to the best investment structure. 

Portfolio implementation via broadly diversified asset class funds provides a consistent ‘true to style’ means of gaining diversified exposure to the market components targeted in the investment planning process.

Asset Class Diversification

An asset class is a group of securities with similar risk and return characteristics.  The ’asset allocation’ decision concerning how an investor’s funds are allocated between these different classes of securities will far outweigh security selection and market timing as determinants of portfolio performance.  The asset classes we focus on are represented by the coloured blocks in the chart below.

The randomness of returns, between the asset classes identified below, demonstrates how problematic attempts to forecast next year’s winning asset class is.  Risk premiums come and go, which means it is most important to be positioned to reap the returns on offer when they arise. 

Diversification by asset class, geographic region and security numbers is recognised best practice for trustees responsible for substantial funds and individual investors alike. 

market timing is risky

It is very tempting to try to time the market, but very few people - not even the brightest professionals - manage to profit consistently.  Large gains come in unpredictable surges and missing only a small fraction of days can defeat a timing strategy.

The chart below shows that a $1,000 investment in the S&P/ ASX accumulation index in June 1992 and left alone for 21.5 years would have grown to $7,644 by December 2013 (an annualised compound return of 9.9%).  However, had just the best five trading days been missed, the balance would have been shaved back to $5,852.  Missing the best 15 or 25 days would have been even more costly.   Of course missing the worst 5, 15 or 25 days in such a lengthy period would be a benefit, but given capital markets have trended upwards consistently over time, missing the days when the market spikes upwards is most costly over time.  Trying to forecast which days or weeks will yield good or bad returns is a guessing game -pure speculation.

the behaviour gap

Research shows that the average investor underperformed both the equity and bond markets over a 20 year period.

The S&P 500 returned 7.81% over the 20 years to 31 December 2011, whereas the average US equity fund investor achieved a return of 3.49% - an equities behaviour gap of 4.32%.  Bond markets show an even greater gap over the same period of 5.56%

This shows the extent to which returns are dependent on investor behaviour, rather than fund performance.  Investors employing a buy and hold strategy typically earn higher returns over time than those who are influenced by emotion and attempt to time the market and often end up buying high and selling low.