The term “Balanced” is probably the most frequently used and yet least understood term in the financial services industry. In an era where regulators have put greater and necessary emphasis on clear client communication and consistent client outcomes, this is a relic of the days where practically anything went in the Wealth Management industry and it was much easier to make positive returns.
“Balanced” can still mean a whole range of diverse things to different people. It is a broad term that could encompass a wide spectrum of asset allocations and completely divergent returns to what one might have been expecting.
The term “Balanced” might also have contrasting connotations in the future as to those it has had in the past; in simple terms, traditional Balanced portfolios could be in for a rude awakening after decades of consistently healthy and relatively easy returns. Indeed, it might be that the first quarter of 2021, when both bonds and high growth equities lost money in tandem, was evidence of the challenge ahead for Balanced portfolios and quite possibly the demise of the famous “60% equities/ 40% bonds portfolio”, which has been the bedrock of most Balanced asset allocations across the investment industry for the last four decades.
Our Aims Today
In our latest View, we will discuss what Balanced means to us at Psigma. We believe that our investment approach is different and how we think about investments will support our ability to deliver upon clients’ aims and aspirations in the future.
We will also address why the “future ain’t what it used to be” for traditional Balanced strategies, and why investors and advisers alike need to think carefully about Balanced investment portfolios in a world that looks unrecognisable to how it has through the last few decades. It could well be that the “Turbulent Twenties” offer up a very different investment environment ahead.
What does “Balanced” mean to us?
It is vital that we strive to provide both financial advisers and clients with as much predictability as possible in a very uncertain investment environment. In truth, terms such as “Cautious”, “Balanced” and “Growth” are imperfect and imprecise guides as to what should be expected from an investment strategy.
Our own definition of “Balanced” might be very different to others’ interpretations of the same moniker. To try and fill the gaps that such terms create, our portfolios have return targets, which we think are realistic aspirations for each level of risk. The return target for our Balanced strategies is the official UK Consumer Price Inflation index (CPI) +3% over a seven-year time horizon.
We have also implemented portfolio guidelines to aid with decisions over suitability. Each of our portfolios has tolerances around asset classes, with fixed minimum and maximum levels for total combined equity allocations and higher risk fixed interest (bonds or credits that can exhibit equity-like volatility). As a guide, Psigma’s Balanced portfolios can hold a maximum of 60% in equities and 15% in higher risk fixed interest. This would suggest that at a point of total optimism, our Balanced portfolios could hold 75% in investments in asset classes traditionally considered to be most volatile and “risky”. However, it is a very low probability scenario where we would use our portfolios’ flexible mandates to that extreme, and we are typically heavily diversified across the 11 main asset classes that we use across our clients’ investment strategies.
Our Balanced model has typically demonstrated an equity beta to global equities of around 0.5xs-0.6xs (in basic terms 50-60% equity risk) over the near 17 years that we have managed our strategies. Whilst not a set aim or target for our Balanced strategy, this is what we would expect from a portfolio that has roughly 60% in “higher risk” and 40% in “lower or low risk” investments.
What about other Balanced strategies?
A by-product of our investment approach is that the risk categorisation of our Balanced strategy falls neatly into the Balanced Asset Category of Asset Risk Consultants (ARC), which interestingly is far from a given across other Balanced DFM portfolios. As a reminder, ARC’s Balanced Asset category includes those strategies that have exhibited a correlation to global equities of between 0.4-0.6xs.
Indeed, if one looks across the Wealth Management industry it is surprising how unbalanced most Balanced investment strategies look by comparison to both ARC’s interpretation of portfolio risk and our own view of asset allocation. This is not to say that others are doing a better or worse job than us with Balanced portfolios, but rather that there is no set approach or understanding of the term “Balanced”, and we appear to be different. Analysis that we have conducted of a range of industry peers’ Balanced MPS strategies shows that the average Balanced portfolio holds roughly 65% in equities, equivalent to the level of equity risk that we would hold on a “High Growth” portfolio. This level of equity risk would also imply that most Balanced portfolios are more likely to be considered as Steady Growth by ARC’s own measure (between 0.6xs-0.8xs the volatility of global equities). Our Balanced strategy currently has c43% in global equity investments.
The most famous of all Balanced strategies
The “grandfather” of Balanced strategies that has underpinned all asset allocations in the Wealth Management industry is the “60% equities/40% bonds portfolio”. So successful has this strategy been at providing consistent returns and protecting against the investment pitfalls of the last four decades that it is almost considered sacrilege to question its suitability for the future. But that is exactly what we will do here!Investors would be wise to remember that investment is a “forward-looking game”, and we stand by our long-held investment mantra that “the past is the past; it is not prologue”. We think it very likely that the returns of this success story will be far less rewarding in the future. Given the combination of high equity valuations and low bond yields, both of which are vulnerable to rising inflation and interest rate risk, there is a fair chance that it fails to meet clients’ return objectives in the coming years. This is exactly what traditional Balanced strategies experienced in the first quarter of 2021, where despite positive economic momentum, investments broadly disappointed, including the worst quarterly performance for high quality bonds since the 1970s
Indeed, using our own proprietary asset class forecasts, we would expect such a strategy to achieve a return of around 3% pre-fees in the next five years, which is nowhere close to the c9% return of the last five years delivered by a UK version of the 60/40 strategy and the c8% average total return of the US version over the last forty years (calculated as 60% US S&P 500/ 40% Global Aggregate index annualised since 31/01/1990). Whilst this future projection might sound conservative, we prefer to be realistic and the truth is that the returns of such a portfolio might disappoint even more than our central case. Moreover, when adjusted for currently rising inflation rates, the prospective “real” return of such a portfolio might well be close to 0% and far below clients’ expectations. This might sound like a “doomsday prediction”, but it isn’t. A lot of it is simple mathematics and a reflection of some of the most expensive cross-asset valuations in history. In truth, if inflation picks up even further, then prospective real returns could be negative. This means that wealth managers, advisers and clients need to think very carefully about their future investment strategy.
How do we manage our Balanced strategies?
It is of course very easy to point out possible deficiencies; it is much harder to suggest solutions to the problems that investors could face ahead. However, we believe that we have sensible methods to generate attractive portfolio returns in the coming years. From a structural perspective, we are aiming for “genuine balance” rather than an equity-dominant approach, utilising widespread diversification and trying to identify differentiated return streams to deliver returns at a time of highly correlated markets. This means that we use both the 11 core asset classes across our portfolios and around 30 sub-asset classes, depending on our interpretation of the macroeconomic environment and sentiment across financial markets.
Fixed income solutions in the bond desert
A key differentiator of our investment strategies is the way that we address fixed income investing. The paucity of future returns and concerns over rising interest rates are probably the key hindrances to prospective returns from the core government bond and high-quality corporate bond elements of the “60/40 portfolio”, and the major reason why many investors are simply giving up on bonds. Our own view is “don’t give up but do think differently”. In our view, there are a range of exciting and enticing opportunities still available across global fixed income markets, with potential returns of 3-6% per annum still viable over the next five years.
Inflation “breakevens” offer investors an efficient and effective way to protect against rising inflation through government bond markets, without embracing significant duration risk. Short duration and selective corporate bonds, particularly those from within the banking sector, can give investors the ability to generate decent levels of income without overly worrying about interest rate rises. Whenever anyone hears about “bank bonds”, they assume that such investments are extremely risky, given the lingering memories of the “Great Financial Crisis” and the various vintages of European debt crises in the last decade, but that misses the point that banks are now far stronger and part of a solution to our economic challenges ahead, rather than part of the problem.
If our forecasts are correct and the short-term economic prognosis is positive, with the likelihood of higher inflation and rising bond yields, then there are still options for investors to select in bond markets to benefit from such trends, even if pressures are felt elsewhere. Rising asset prices and strong economic growth are characteristically positive dynamics for asset-backed securities and we continue to favour such investments across our strategies, particularly given the higher income levels available when compared to similarly rated corporate bonds. Furthermore, the “floating rate” nature of such bonds also provides further inflation and interest rates protection to our Balanced portfolios. In addition, emerging market debt continues to present investors with higher yields in an environment where strong economic growth should help the industrialising world to recover from the COVID-19 shock.
Equities punching above their weight
Our own research and feedback from advisers imply that our Balanced strategies have a lower weight in global equities than our peers, and certainly a lower percentage than the traditional “60/40 portfolio”. This reality should not be read as the fact that we don’t like equities. It is rather that we do not believe that a Balanced portfolio needs to be overly exposed to any one asset class to achieve its aims. Instead, we try to find specific equity themes and ideas to make our allocations work harder, and aim to use both higher weights in specialist credit markets and various alternative investments to try to create equity-style returns with lower volatility. Were we to see a period where equity valuations traded at more realistic or even cheap valuations, something that we haven’t seen for over a decade, then our propensity for equity exposure would undoubtedly increase.
Even though headline equity index valuations are expensive, and complacency currently rules across global stock markets, we are pleased with the range of specific and selected equity investments that we can find. There are both good valuation opportunities and exciting growth themes in an assortment of regions and sectors. One notable factor that has led to most traditional Balanced strategies underperforming this year has been the return to favour of global value shares. It is inescapably obvious that investors are underexposed to the post-COVID “reopening trade”, and we continue to admire selected opportunities in perceived value or economically cyclical sectors.
Staking one’s whole equity allocation on value themes could well lead to a poor portfolio outcome and client disappointment, should economic activity not reach the heady heights that most economists expect it to as we shake off the restrictions that COVID has thrown around us. The good news is that there are also a fair number of attractive growth themes that we can embrace for our clients. Chief amongst them are the energy revolution and medical development, both of which should benefit materially from future economic trends. Governments and companies appear to be moving quickly down the path of renewable energy, from which there is no return, while COVID will inspire an acceleration in the golden age of medical technology, which should bring rich rewards to investors. In addition, we recognise that, through the “Build Back Better” philosophy of authorities around the world, spending on infrastructure will increase in the coming years, and we are exploiting this theme for clients in our portfolios.
We would also urge all investors to be global in their approach. Right now, we do see good relative value in UK equities, but some of the best opportunities that we can pinpoint are in the Far East, with both Asian consumption and Japanese corporate change two of the structural long-term investment themes within our portfolios. The former is a tale of sustainable long-term growth, while the latter is a case of realising value from inefficient Japanese companies, who are being forced to reassess how they manage their assets after three decades of lacklustre performance.
As you can see, both the specific opportunities in Asia and the rest of our equity allocations are diverse but focused on the brightest opportunities in global equity markets. Our equity allocations might look comparatively “lightweight”, but we believe they pack a mighty punch.
Use of Alternative Investments
The term “alternative” has almost become an investment “swear word” after woeful performance of many hedge funds, absolute return strategies and a whole host of esoteric investments in the last decade. In many cases, such a negative view is deserved, but in others it is not. We believe that it is possible to add suitable alternative strategies to a Balanced portfolio to complement the larger weights in global equities and fixed income markets. Investments such as commodities can provide inflation protection, an exposure to gold can deliver downside mitigation in periods of genuine market stress, and simple options strategies can provide more certain outcomes in core asset classes, without taking unnecessary risk. Moreover, at a time when markets have become increasingly correlated and investments that have been historically unconnected all march together to the beat of the same drum (persistently low interest rates), it is still possible to find authentically uncorrelated investments in the “alternative” space, such as global macro investment funds, that can diversify one’s portfolio and provide something to protect against systemic market risks. It is such investments that allows us to view our Balanced strategies as “genuinely Balanced”.
What we don’t do
The key thing to note about our Balanced strategy and any of our other strategies is that we don’t consider anything that we invest in to be excessively complicated or worryingly illiquid. All the investments we own are daily dealing UCITS-compliant funds. We also avoid illiquid property funds and complicated investment structures, such as structured products. We believe there’s merit in keeping it simple and the returns we have delivered over the last 17 years are hopefully testament to that.
There is no standard definition for the most popular investment term in the Wealth Management industry. Balanced can mean a wide range of different things to different people, thereby impairing advisers’ ability to achieve consistent client outcomes and help clients with individual decisions over suitability.
One of the key aims that we set out in shaping our business was that we wanted to be “the most Balanced of Balanced managers”. “Balanced” to us means appropriate diversification, less of a reliance upon equities and sourcing different investments for distinct roles in a portfolio. Our focus on inflation protection and fixed income solutions doesn’t make us better investors than anyone else, but we believe that it gives us a differentiated solution. We think this is vital to achieving success in the evolving investment landscape and can help clients achieve their investment aims and aspirations in the future, whilst providing comfort to advisers making decisions over suitability for their clients. The last four decades would suggest that traditional Balanced investing is easy, but we would encourage investors not to be complacent. As John F. Kennedy once said, “Those who look only to the past or the present are certain to miss the future”. The future for Balanced investors is likely to be much more difficult, but there are solutions aside from the “60/40 portfolio” and the time to act is now.
Tom Becket, Chief Investment Officer
This communication is prepared for professional advisers and is in tended to provide information only. The information contained within this communication has been obtained from industry sources that we believe to be reliable and accurate at the time of writing. It is not intended to be construed as a solicitation for the sale of any particular investment nor as investment advice and does not have regard to the specific investment objectives, financial situation, capacity for loss, and particular needs of any person to whom it is presented. The investments contained in this document may not be suitable for all investors.
- The value of investments and the income from them can fall as well as rise. An investor may not get back the amount of money that he/ she invests. Past performance is not a guide to future performance.
- Foreign currency denominated investments are subject to fluctuations in exchange rates that could have a positive or adverse effect on the value of, and income from, the investment.
- Investors should consult their professional advisers on the possible tax and other consequences of their holding any of the investments contained in this publication.