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How investors should allocate their assets in the ‘new normal’
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f you mix assets with different characteristics, says modern portfolio theory, then, for any given level of risk, an investor can achieve a higher average return. This still holds true. A famous study by Brinson, Singer and Beenbower found that 92% of investment returns came from asset allocation. Indeed, nearly all studies show it to be the single largest contributor to returns. Yet, in the ‘new normal’ which applies to investing today, the mix includes not just equity, bonds and cash but alternative types of assets too. The latter covers everything from commodities to hedge funds, private equity and real estate. As alternatives become more liquid and accessible to investors, bonds as a proportion of the total are likely to fall. Stocks tend to climb in value as recessions near their end; rising inflation usually signals the peak in a cycle of economic expansion. So investors use what is known as dynamic allocation to ‘lock in’ profits if the return is ahead of its target. Two further forces have combined to undermine accepted practise as the world economy struggles to regain momentum. The first is the rise of emerging markets and the fact that their economies are likely to keep growing faster than those of developed ones. This implies that the proportion of assets allocated to emerging markets must climb from its current level of 5-10% of equity and bond portfolios.
Some pension funds and endowments already devote as much as 30-40 % of their assets to alternatives, particularly over longer periods. But which benchmark should they use? Those introduced by Morgan Stanley Capital International (MSCI) are the de facto standards of equity investment the world over. But there is a problem. While such benchmarks are a measure of capitalisation, they encourage investors who track them to buy more of the shares of companies whose capitalisations are rising, and to sell those which are not. The result is that investors tend to buy when the shares are high and to sell when they are low. One way to avoid this trap is to allocate investments on the basis of GDP instead of market capitalisation. Evidence shows that investors suffer less from volatility and can outperform the MSCI global equity index by as much as 5% a year.
Sustainable Investment
A second unknown is the effect on investment of sustainability. Resources will become constrained as the world's population grows and people become wealthier. This, in turn, will require more investment in energy, food and water. Take the worldwide consumption of meat. Since 1985, demand has more than doubled as emerging economies became wealthier and people aspired to richer diets. Since agriculture uses 75% of the world's water, the effect on natural resources is also marked. Simply getting
water to where it is needed will become a problem requiring huge amounts of investment even in the developed world. By 2020, half of US distribution networks will need to be upgraded. So far, the institutions that have put most weight behind emerging markets have been those prepared to escape the constraints of benchmarks based around market capitalisation. Many have begun to look at natural resources and sustainability and how such themes can be incorporated into asset allocation. We believe that a thematic approach to investment which concentrates on the mega trends affecting economies today – such as population growth, urbanization and the demand for infrastructure of all sorts – could benefit investors. Not only is such an approach by definition longer term; it also helps asset managers and so investors to capitalise on the opportunities which are spurring developing economies. Since the beginning of 2006, when the UN Principles for Responsible Investment were launched, more than 600 asset managers have signed up to them. More important, the amount of money in their charge has also climbed, to more than $10 trillion at the last count. It is no surprise then that more and more asset managers promote sustainability as a way to prove their credentials. So much so that sustainable investing could soon become an asset class of its own n
By Douglas Hansen-Luke The Middle East CEO for Dutch investment manager Robeco. The views expressed below are personal and do not necessarily reflect the views of Robeco, its parent Rabobank or any affiliated company.
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