Fundhouse Insights Investment Clarity Blog

The Asset Allocator’s Dilemma: November 2021

November 16, 2021 by

As we conclude our client quarterly investment committees, we are struck by how odd the market has become. Over many years now, we have seen the market invert past norms and this has significant and unique consequences for how you build a portfolio for a bear market.

Where we are today: There is no hiding that we are nervous of markets. For the first time we can remember, prices are exceptionally high across most asset classes at the same time. US house prices are at record highs (as a percentage of household income), bond yields are at unprecedented lows, commodities ex energy (S&P GSCI Non Energy) are back to the peaks of 10 years ago at the top of the super cycle and US equities are at extreme highs. We find no precedent for this, where all major asset classes are expensive together. Take two recent equity market peaks, 2000 and 2007. Back in 2000, REITS paid out dividends of over 8% (inflation was under 2%) and Gilts offered a real yield of around 3%. And in 2008, Gilts and corporate bonds also offered very healthy real yields. Today pretty much all mainstream income producing investments run at substantial negative real yields. Being defensive seems rational.

How do you build a defensive portfolio? The behaviour of asset classes during past bear markets would usually be instructive. Below we show a chart that reflects the excess returns of ‘safe’ and ‘risky’ assets during 3 recent stock market sell offs. As you may expect, history suggests that ‘safe’ assets are sensible and ‘risky’ assets aren’t:

  • Government bonds have been the ultimate safe haven.
  • From an equity style perspective, defensive, high quality equities have offered better downside protection.
  • US equities usually outperform other regions, as investors seek the safety of the world’s biggest equity market.
  • Emerging markets have sold off more than developed, as investors flee the ‘risky’ developing markets.
  • Small caps lose more than mega caps, on average, because they are seen as riskier.

Asset Class Alpha vs Developed Market Equities During Last 3 Bear Markets

Is history a sensible guide for today? When we reflect on the patterns we see in the current data, it inverts many historic norms: in a strongly rising market across almost all asset classes, we find expensive has beaten cheap, large (mega cap) has beaten small, developed has beaten emerging and defensive has beaten cyclical. Does this suggest an equally unique approach to defensive asset allocation may be called for? If so, it poses a real dilemma.

The dilemma: For the first time, the family of ‘safe’ assets are expensive. The dilemma is this: if you are bearish, you can follow history and own overpriced ‘safe’ assets because of how they behaved during prior down markets. Or build a portfolio that favours cheap (historically ‘riskier’) over expensive: avoiding bonds, high quality equities and mega caps, while favouring emerging markets and cyclical equities. On paper, that is a bull market portfolio, built by a bear. Is it time to totally bet against history? If you look at valuations, probably.

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