By Patrick Nolan, portfolio strategist at BlackRock Portfolio Solutions.
Patrick Nolan, portfolio strategist at BlackRock Portfolio Solutions.
In an era when equity returns are relatively easy to come by, yields remain low, and volatility barely makes a ripple, it can be a challenge to contemplate how to build portfolios for the next market cycle. How can you prepare for a time when the ups and downs of owning stocks may be significantly bumpier than it has been for the past eight years?
Asset allocation products – those designed to blend stocks, bonds and other investment types into a single investment – can fit the bill by helping provide unique return streams to investor portfolios. Already, investors are paying closer attention to high equity valuations. As markets grind higher, investors are considering how to carefully participate while seeking to defend their portfolios from an eventual turn. A growing number are looking to asset allocation products as a way to manage both goals.
Asset allocation ascendant
The Portfolio Solutions team at BlackRock analyzes thousands of model portfolios submitted by financial advisors each year. Of the more than 6,400 portfolios we’ve collected in the past 12 months, 42% contain asset allocation funds – a surprising figure given that most advisors that we work with consider themselves asset allocators and portfolio constructors in their own right.
Further, according to a recent McKinsey report, asset allocation strategies may see $1.2 trillion in net inflows over the next five years.
The evolution of a category
While the first balanced mutual fund was created in the 1920s, the growth of that category was predicated on the benefits of blending stocks, bonds and cash in a portfolio. The birth of the modern-day asset allocation product traces back to the 1970s, when investors gained access to a larger universe of investments, such as real assets and currencies, plus the expanded use of a growing derivatives market that offered more precise exposures and better hedging techniques – all in a single product aimed at creating a specific investment outcome.
Prior to the emergence of this new product type, few could access some of the exposures these funds offered, nor capitalize on the risk-adjusted return benefits of including them in a portfolio. Given their permission to invest in the widest available spectrum of securities, and guided by trained investment professionals, the value of these funds often shone the brightest during some of the darkest days in the markets.
Which brings us to today. As easy US equity returns have now run on for many years, industry trends shifted in favour of exchange-traded funds (ETFs) that track specific areas of the market, like the 500 largest US stocks. Largely as a result, ETFs have experienced a tailwind at the expense of active strategies, including broader-based asset allocation products.
That said, investors who make portfolio decisions based on recent performance may be inviting complacency. This practice can lead to poor results, particularly during periods of transition within a market cycle. We expect the inflows predicted by McKinsey to materialize particularly if equity market returns flatten out.
Three-year rolling comparison of multi-asset funds to the S&P 500
Source: Morningstar, excludes TDFs in all versions of the analysis. Rolling three-year returns in monthly steps, 1/1/97 to 31/12/16
Getting there from here
Alongside the growing use of ETFs has been the rise of “goals-based” client service and “outcome-oriented” portfolio construction. These two trends aren’t unrelated. Indeed, one reason for the popularity of ETFs is the cost efficiency of these vehicles. However, there is a second dimension to efficiency that may get lost along the way – managing how to generate the target return with a volatility level an investor can tolerate.
This second dimension is underappreciated as global markets grind higher with little volatility. Since the 2008 crisis, easy-to-access exposures have generated above-average returns – the S&P 500 being a primary example. However, if stock market returns wane in the coming years, as BlackRock’s capital market assumptions suggest, then we will need something more – something that allows us to create excess returns more consistently, and do so in a way that doesn’t create too much portfolio risk.
Said differently, if my car ran out of gas, and the nearby gas station is only 100 yards away, my ease in pushing the car there depends on the terrain. If it’s all downhill, I should be able to push the car to the gas station all by myself with little strain. However, if it’s uphill between me and the gas station, I will not be able to get it there myself. I will need help. This is the difference between the markets providing above-average or below-average returns.
Despite the terrific market returns investors have experienced during this decade, what got us here won’t likely get us “there.” As investors peer into the future and contemplate the potential for lower market returns, we see few options with greater versatility and more powerful risk-adjusted return potential than asset allocation products. They deserve a look.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)