Asset Allocation In the 2020’s

The negative / low rate reality has become even more real of late. As you can see in the chart below, which shows swap curves in CHF, EUR, JPY, GBP, USD and CNY:

• EUR rates are now mostly negative and below Japanese rates across the curve
• CHF rates are even deeper into negative territory
• UK rates are below 0.5% across the entire curve
• US rates are below 1% across the entire curve
• Less widely held Chinese Sovereigns are the exception though yield less than 3.5% for 30Y

Chart 1 — Selected Yield Curves as of 12 May 2020

Source: Bloomberg

Regardless of potentially different central bank policy rates and government fiscal policies the global investor’s “hunt for yield” will keep some of these curves highly correlated and bunched together going forward. For example, Reuters recently noted: “Dollar hedging costs since the virus outbreak have declined by as much as 100 basis points for European and Japanese investors, two of the biggest overseas buyers of U.S. assets.”

The investment implications of lower yields are not new to investors as it has been a phenomenon in Japan for decades and the rest of the developed world for many years. In fact we published an ALPIMA Insight on the topic just over four years ago.

But the economic effects of the pandemic are making the situation more pronounced, and most likely long-lasting.

Investors have adapted to low rates by accepting the risks of moving out in duration and/or down in credit quality and/or of enhancing returns with, in broad terms, selling volatility. Unfortunately a side effect was the creation of ‘risk on/off’ markets with reinforcing feedback loops which we have also written about in the more recent past.

Pictorially the example below shows how one quantitative asset allocation logic, which has consistently generated good risk-adjusted returns, had very different pre- and post- 2008/09 asset allocations.

Chart 2 — Historical Allocation Profile of Risk-Based USD Multi Asset Portfolio

Source: ALPIMA

A major potential issue going forward into the 2020’s is that the risk/reward balance of the choices of longer duration, lower credit quality and selling volatility are likely to be worse than in the past.

Therefore, asset and wealth managers require a careful rethink of their asset allocation processes. The 60/40 portfolio, while intuitive, no longer makes sense and the traditional Modern Portfolio Theory framework can fall short in this environment.

Below are a few ways to adjust the asset allocation process to the new world:

• Carefully re-calibrate expected return assumptions for fixed income assets — CMAs produced pre-Covid no longer make sense today
• Re-calibrate fixed income allocation constraints in risk-based allocation frameworks — reducing exposure to the riskier parts of the curve
• Consider using Black-Litterman methodology to take updated views into account, using either fixed weights or a risk-based allocation as a prior
• Ensure Monte Carlo-based optimisations take into account the current level of interest rates
• Revise stress test assumptions
• Scale into and out of risk with volatility targeting

Thanks to its versatile interface and powerful quant API, the ALPIMA platform is uniquely able to help you explore these and other ideas in order to help you rethink the asset allocation process for a new world.

Contact us at info@alpima.net to find out more.