Consultants pay lip service to global asset allocation but, in practice, constrain managers who want to do it, says Andrew Dalton.

For the last ten years at least, trustees and consultants have paid lip service to global asset allocation but, in practice, have sought to constrain managers who want to do it properly. There has been an assumption that the trend in equity markets is more likely to be up than down and that in the end this rising tide will carry all before it. We have been encouraged to adopt equity orientated benchmarks – 50:50 equities/bonds for the nervous or 70:30 equities/bonds for more long-term, growth-orientated portfolios. There has been a move towards alternatives and towards absolute return strategies. But the sad fact is that over the last ten years, none of these strategies has worked well. Indeed, for a UK-based investor only very specific areas of equity diversification have added any value.

The statistics are simple. Over the last ten years, the FTSE All-Share index has returned on average 2.04 per cent per year, the S&P 500 index, expressed in sterling, has had a negative return of -0.94 per cent per year and the MSCI World index has had a negative return of -1.53 per cent per annum. Meanwhile, in Japan, the annualised return expressed in sterling of the Topix index has been -4.1 per cent per annum. Only in Asia ex-Japan and possibly in certain specifically natural resource orientated markets, like Canada, has there been value to be gained from diversification. The MSCI Asia ex-Japan index over the last ten years in sterling has produced a return of 5.02 per cent per annum and the Canadian market a return of 9.01 per cent.

The difficulty, of course, is that the world has had two equity bear markets in the last ten years. Truly, the last ten years have been a ‘blue moon’ decade. Consultants and others may well argue that taking the long-term view, looking back, say, to 1900, all these bear markets are but blips on an ultimately rising trend. They may be right, but the analysis is backward-looking and will take another 100 years to prove. Meanwhile, charity investors are faced with a seemingly intractable problem. Can they recover the growth that they experienced in the 1990s and still meet the ongoing cost of their charitable activity? The blithe assumption that it is fine to spend 3 or 4 per cent of net worth each year safely in charitable giving is being called into question now. For many charities, investment returns over the last ten years have been next to nothing and charitable giving cannot be sustained at that sort of level.

Investors, therefore, have to face the fact that they need to lower their targets and increase their flexibility. Whether equity markets will be higher in 100 years from now is unprovable but the thought that equity markets are cyclical is obvious. Markets both go up and go down, some much more than others at certain times.

What we need is an asset manager who will get us in at the bottom and out at the top of each cycle. It sounds easy but we are led to believe that it is difficult. The truth lies somewhere in between.It is hard to pick the top or bottom of a market cycle to within a day. However, the factors that determine whether we are in a bull market or a bear market are relatively straightforward. They are broadly the same for each market, although those markets may vary one from another from time to time. Inevitably growth comes from a diversified range of sources. It is diversified by geography, by company, by theme and by politics and policy.

The first step towards a sensible globally diversified growth portfolio is to provide the investment manager with a cash-plus target. By providing a cash target the client removes any inbuilt incentive to remain invested in equities in a bear market. The second step is to appoint a manager who understands risk and measures it. Equity risk, in particular, varies inversely with the cycle. For long periods of time, equity market risk may remain in single figures but, in times of stress, can spike sharply. It is necessary to measure actual portfolio risk over different periods of time and also correlated risk – in other words, the risk if every single position goes wrong at the same time. This was what took place in the second half of 2008. At that time, actual portfolio risk was very similar to correlated risk. In other words, there was nowhere to hide. Only cash provided any reduction in volatility.

Thereafter, the determinants of the cycle are relatively straightforward. The most powerful generator of a cyclical upswing is the creation of excess liquidity. Liquidity is created by central banks and disintermediated through the commercial banking system. It is possible, of course, for central banks to create an enormous amount of liquidity but for that to have little effect on the commercial banking system, if the system is unwilling to act as an efficient disintermediator. This was true in Japan throughout the 1990s, it was true too in 2008 when all commercial banks retrenched at the same time. Another powerful determinant of a change in cyclical direction is the movement of short-term interest rates. If, as is the case now, short-term interest rates are very low, that should be a warning to investors that  hanging on to their cash is probably counter-productive because there is no reward in doing so.

Another indicator is the rising momentum of corporate earnings. People who buy equities are, of course, buying companies and companies have earnings. If, like now, a profit explosion is taking place, albeit from a low level, this process should inspire investor confidence.

Valuation is another important tool. However, it is worth remembering that at market lows, when earnings are cyclically depressed, valuations may look high and vice versa. Valuation typically is not an indicator of the direction of market movement but, if the other key factors have been withdrawn, it gives the manager an idea of the amplitude of the move that may follow. A market that has been buoyed up for all sorts of reasons will fall much further if the stocks in it are over-valued. We saw that when the dot.com bubble burst.

If I make it sound too simple,  it is worth bearing in mind that there are lots of moguls. Most of these traps are political. Policy-makers make mistakes. ‘Light touch’ banking regulation was a mistake.  A currency peg may, in circumstances, be a terrible mistake as the Thai government found in 1997.

Investors themselves make mistakes. They forget the value  of liquidity. They lock themselves  up in investments they cannot extricate themselves from. They  may adopt a herd-like mentality – seeking to track the CAPS Median  is an extreme example.

At the end of the day, active asset allocation is a real skill.  To flourish, it should not be constrained with inappropriate benchmarks. It requires nimbleness and concentration. Above all, it needs a manager with experience, looking in the right direction for those things that really matter.

Andrew Dalton is managing partner of Dalton Strategic Partnership