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Multi-Asset and the Changing Nature of Asset Allocation

Updated: May 18, 2022

Financial advisers will be only too aware that the difference between a comfortable retirement and an uncomfortable one is almost too huge to contemplate. And yet it is very possible some are making a simple and irreversible mistake that could ruin the chance of their clients achieving that long dreamt of cruise in the sun or leaving something for their offspring.

"Clients are likely to be waving goodbye to that cruise ship as it sails over the horizon"

The mistake I am referring to is having the wrong asset allocation for a client's retirement savings specifically, too many government bonds and too few equities. Three decades ago, buying and holding to maturity the 17year Gilt would have made you £474,350 of real capital on an initial investment of £100,000. Buy the 1.25% 22/11/32 gilt today note this comparison uses an inflation linked bond as a proxy for what to expect in real terms from nominal bonds and you will lose £14,672 of real capital. To put it another way, multi-asset funds and their core function of asset allocation have never been more important for investors and their advisers

Now I hopefully have your attention, let's take a few steps back. First, multi-asset investing is not new. In fact, it is as old as the hills. For centuries, sensible investors have been spreading their investments across a range of assets. What may be changing, however, is how asset allocation should be


When I began my career in 1988 with a large UK fund management house, most of the firm's assets under management were ‘multi-asset' in the form of defined benefit pension scheme assets. Many of these funds had around half their assets invested in UK equities, another fifth or so in overseas equities, another fifth in bonds and the rest in property and cash. To all intents and purposes, they were multi-asset funds. We just did not call them that.

Then, over the course of the next couple of decades, the consultants took over, recommending to pension fund clients which manager they should select to manage which bucket of assets. They themselves would take on the job of asset allocation, while fund managers would be picked on the basis of their selection skills in equities, bonds or other asset classes.

To be fair to the consultants, the existing asset allocation function was ripe for an overhaul. At the firm where I started, it was the manager of the UK equity portion who was the central figure, with the job of asset allocation left to one individual who every quarter would look at the positioning of other pension funds, as provided by CAPS or WM, and tweak weightings accordingly. It was not sophisticated and the investment consultants, with their clever mean-variance optimisation models, had a field day.

While clever, however, these models were also flawed. If the volatility of a particular asset class fell, the models, which sought to maximise volatility-adjusted returns, would recommend increasing the allocation to that asset class.

And yet equities are most volatile when they have just crashed and least volatile towards the end of a bull market or sustained rise so the models were essentially programmed to buy high and sell low. Not one of the better investment strategies then and these weaknesses were painfully exposed during the global financial crisis. Many have since been searching for a better way of making asset allocation decisions.

There is plenty of academic research that identifies strong links between the starting valuation of a market or asset class and subsequent medium-term returns. This can be understood most easily with inflation-linked ‘safe-haven' bonds we have chosen these to counter the risk of default where a bond on a real yield of 5% will do better than one on 4%.

With equities, it is a little less intuitive. Those who believe in efficient markets would argue a high dividend yield simply means markets are discounting the ‘fact' that dividends are going to fall. In reality, this is not the case high yields in relation to historical averages portend above-average returns and low yields the opposite.

Yale's Bob Shiller has done a lot of research in this area and he argues, as many others have also since, that the cause of this apparent market inefficiency is behavioural that is to say, animal spirits from time to time cause investors to herd, driving valuations either to unsustainably high levels or to unsustainably low ones. So, an asset allocation model that is based simply on valuation that is, dividend yields in the case of equities, real yields in the case of ‘safe-haven' bonds and spreads in the case of high-yield bonds we think makes a lot of sense.

A lot of the time, of course, valuations will be close to their historical average and that is OK – asset allocation does not have to add value all the time. Waiting for the aforementioned extreme valuations to come along, then pouncing, is a strategy that should produce good results.

All this talk of extreme valuations brings us back nicely to where we started. Long-term real government bond yields in most, if not all, advanced countries are now negative. It is certainly possible they will perform well in the short term if real yields or inflation fall further but, over the longer term, one is

likely to lose.

What could go wrong? For long-term Gilts to continue to perform as well in real terms as they have over the last 30 or so years, future inflation would have to average around 5% a year and never before has there been deflation anywhere close to this.

To find the UK's worst 20-year period of deflation, you have to go all the way back to the period from 1317 to 1337, when consumer prices fell 42% in the wake of the Great Famine of 1315/17 and other natural disasters that followed soon after. This is far cry from what would be required to generate the 6.9% real return achieved by buying and holding to maturity the 10% Treasury Stock 2003 issued on 24 January 1986.

If you define risk as volatility, be my guest and load up on long-term Gilts the UK government has its own printing press so they are never going to be that volatile. But if you worry, as we do, about the potential for permanent loss of real capital, then please beware.

Of course, it is all very well suggesting investors steer clear entirely of the asset class that has in the past been the foundation of a balanced portfolio, but what might they buy instead? For those not inclined to load up on equities which anyway tend to be less risky than is generally perceived because companies, unlike bonds, have the scope to adapt to their environment we would look at what we call specialist assets. For us, these are listed closed-end vehicles that invest in assets such as property, wind farms, planes, infrastructure, and peer-to-peer lending platforms. They generally have decent yields and so offer a good alternative to bonds. But they also have stable cashflows that tend to be index- linked thereby offering a good alternative to equities.

Multi-asset investing and asset allocation have never been more important. Get the latter wrong, and clients are likely to be waving goodbye to that cruise ship as it sails over the horizon.

Published in Professional Adviser

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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