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The 'big question' for asset allocation

The holiday season provides a rare opportunity to ponder the ‘big questions’ in life. Since my professional focus is asset allocation and how investment markets work, it gives me a chance to think about the one ‘big question’ that has fascinated and puzzled me for 30 years.

Where have we been, where are we going?

This is not the ‘big question’ but a quick recap first. Asset markets have been fine this year. While most commentators were nervous all year wondering where to invest, since every market appeared to be over-priced, for me it was more a question of what not to invest in. Stock markets globally have provided benign to moderate returns with low volatility, plus a nice extra boost to returns from our falling dollar. Bonds and real estate markets have also done well in Australia and around the world. With just about every asset class generating benign to moderate returns or better, and with relatively low volatility, the main asset class we were underweight was cash, which lost money in real terms after inflation.

Forming views on the outlooks for markets and asset classes in the coming year is critically important of course. There will be plenty to think about over the holiday break: US rate hikes, China’s lending binge, Japan’s stimulus programmes, European fiscal deadlock, America’s government funding crisis, global banking reregulation, the shale revolution, OPEC’s declining role, Russia’s expansionist plans, ISIL and the west’s reaction to it, Iran’s nuclear ambitions, China’s rising territorial disputes in East Asia, political fragmentation everywhere, and so on. Studying the likely impacts is fascinating and all-consuming for me. It is all I think about all year.

It is difficult enough as it is, but that is not the ‘big question’ for me.

The ‘big question’

As an asset allocator, the single ‘big question’ for me has nothing to do with China or Europe or the US, or oil or share prices. The ‘big question’ is this:

If every long term investor in the world has pretty much the same goals for their investments, and if they all have access to pretty much the same investments globally, then why are there so many different and completely opposite views on how to use those same investments to achieve the same investment goals?

Long term investors share the same goals

Let’s look in a bit more detail. Just about every long term investor in the world has the same main goals they want to achieve from their investments:

  • Protection of capital
  • Preservation of real value after inflation
  • Reasonably reliable regular income stream (either now or in the future)
  • Careful real growth

By ‘long term’ I mean several decades, multi-generational, or perpetual. These four fundamental goals are the same for all types of long term investors - from perpetual charitable funds and endowments, institutional pension funds, right down to individual self-managed retirement funds. I spend my life talking to managers and trustees of long term investment funds, from $100+ billion pension funds to mums and dads who run their own retirement funds of a few hundred thousand dollars, and I have found that their objectives all boil down to these four fundamental investment goals.

Long term investors have access to the same investments

These days everybody – from a $1 trillion dollar fund to my kids’ savings funds – can access countless markets via their on-line broker accounts. Anybody can buy any security on any market in just about any country from just about anywhere.

Even ‘wholesale’ funds like hedge funds, private equity, venture capital, etc can be accessed in small parcels in numerous forms and structures. Large ‘lumpy’ assets like office towers, shopping centres, power stations, electricity grids, airports, toll roads and rail networks can be accessed by unitised or listed securities in hundreds of markets around the world. All are available online with a few clicks of a mouse or taps of a finger on a screen – from anywhere in the world.

One initial reaction might be to say, “That’s not really important or relevant because Australian (or German or Vietnamese etc) investors have Australian (or German or Vietnamese etc) investment goals and should only be worried about Australian (or German or Vietnamese etc) returns and Australian (or German or Vietnamese etc) inflation, and therefore they only need Australian (or German or Vietnamese etc) assets.

I am often asked why investors in one particular country need to worry about global returns, global inflation and global investments?

In the case of Australian investors the answer is simple. Most people want to maintain the global spending power of their money in order to maintain their real standard of living. In Australia, almost everything we buy and use every day is imported, so we need to maintain the spending power of our money in terms of items we buy from global markers. Those few things that are made in Australia (mostly fresh food) are made with imported machinery. In addition, if people want to travel in future they need to maintain the global spending power of their money.

So even local investors need to think about their goals in global terms and think about how they can achieve their goals using the same universe of global investment available to everybody everywhere.

Vastly different, divergent and opposing strategies

With the same goals and access to the same investments globally, then I would have thought that there would be some widely-accepted views or strategies as to how to use those investments to achieve those goals. But there are not. Far from it.

It is not as if there are two or three or even a handful of basic strategies for building the ‘perfect’ investment portfolio. There are hundreds of different types of strategies. It makes no sense to me.

For example, this year I talked to the head of one of the largest pension funds in Korea and they have an allocation of 90% global bonds, of which 70% were government bonds, with the balance being in short term securities, and no shares whatsoever were allowed in their investment mandate. I talked to a sovereign wealth fund in Europe that invested only in bonds, real estate and cash.

I spend a fair bit of time talking to family offices in Asia (mostly Chinese billionaires who have large multi-generational investment funds away from their business wealth) that have a huge range of asset allocations, from 100% cash to 100% precious metals, plus dozens of different strategies in between.

In one of the largest and deepest markets of all – the US charity and endowment market - there are several regular publications that spout an extraordinary array of weird and downright wacky investment strategies each month. All the funds have the same spend rule each year, the same perpetual investment horizon and the same fiduciary obligations, but with an amazing range of investment strategies and approaches.

Australian investors, including wealthy families, charitable funds and retirement funds, have a pronounced liking for Australian shares and an unusually negative predisposition to foreign shares, but New Zealand funds and individuals have always favoured foreign over local shares. I frequently come across Australian wealthy family and retirement fund trustees who are often wedded to a default allocation of 100% Australian shares, and I have a hard time convincing them to diversify into anything else. At the same time I talk to Asian pension funds and billionaire family offices that will not touch shares at all.

Investment management is not a profession yet

If I had leaking plumbing and I called 100 plumbers to fix it, they would all turn up with pretty much the same set of tools in their tool bag and they would probably have one or two different ways of fixing the same problem with the same set of tools. If I had a broken leg or a brain tumour and 100 medical professionals looked at the problem, they would all be armed with similar sets of tools and methods and potions. The 100 professionals would probably come up with perhaps three or four fundamentally different approaches to address the same set of symptoms.

However if I ask 100 long term investors how to achieve the common set of goals listed above, I would get dozens of completely different and opposing strategies. There would be 100 different asset allocations, and little in the way of considered, reasoned supporting arguments or evidence that they are likely to work.

It is not as if this is a new field. Investment markets, and the idea of managing long term investments, have been around for hundreds of years. The more time passes, the greater divergence of strategies. This is what puzzles me intellectually, and it also worries me deeply because peoples’ life savings and their future livelihoods are at stake.

Given the extraordinary range of different strategies, the chance that their money is invested in the right way to achieve their goals is quite small, and the chance their money is invested in other inappropriate, harebrained, or downright bad strategies is quite high.

Complexity is not the reason, but nothing is more complex than the human body. Even after hundreds of years of scientific endeavour and effort, scientists have little idea how the human body actually works. We only let a surgeon loose on patients after more than a dozen years of extremely intensive training, and there are detailed rules, procedures and protocols that must be followed. With investing, just about anybody with a hot idea is allowed to manage money.

It does not look like a profession, such as plumbers or surgeons. It looks more like an experimental free-for-all where anything goes until it blows up!

This then is the ‘big question’ for me as an investor and asset allocator and what I will have time during the holidays to ponder.

Ashley Owen is Joint CEO of Philo Capital Advisers and a director and adviser to the Third Link Growth Fund. This article is for general educational purposes and is not personal financial advice.

Chris Eastaway
January 04, 2017

Ashley, c'mon - this is killing me now....

Chris Eastaway
November 16, 2015

Ashley, I have been waiting with lured anticipation to hear how your holiday ponderings of the “Big Question” played out at the end of last year. It hardly seems fair to leave such an interesting question on the table for this long. So, how about an early Christmas present for the ardent Cuffelinks readers? I’m sure I’m not alone in looking forward to your follow up to this article (your time permitting, of course).

David Esser
December 31, 2014

It is very subjective on whether a company is well managed or not. It really depends on whether you have a long term or short term view. In the resources sector 'risk capital' is required to pay for the acquisition and exploration of projects (grass roots to brown fields) and to explore them. If 'activist investors' decide they no longer wish to fund exploration projects, as it is no longer flavour of the month, then that is not the same thing as the board 'mis-managing the company'. This is conflict of interest between short term investor interest and mid - longer term company interest in realising value from a mining / exploration project.

Geoff Walker
December 22, 2014

Ashley, I have to take issue with your claim that Australian investors need to think globally in order to maintain the spending power of their money.

Maintenance of spending power is important to all Australians, not just investors. So on that basis I await with interest to see if a campaign by wage earners emerges for their pay to be reconstituted from purely AUD to a basket of currencies reflective of the sources of Australia's imports. But I won't be holding my breath!

My belief is that a better hypothesis is that Australians are concerned with maintaining their spending power not in TWI terms but relative to the community, ie keeping up with the Joneses, and therefore should be aiming to generate income that grows in line with AWE, which of course is denominated in AUD.

IMHO, those wealthy Australian families and trustees whose investment strategies perplex you have very good reason to maintain their focus on Australian shares.

It puzzles me why advisors would promote mismatches between their clients’ investment assets and the income streams that the clients desire to see generated.

Peter Vann
December 20, 2014

I had a chuckle when I read your words "experimental free-for-all". It sort of is like that!!
It reminded me of a remark I periodically make about how research into understanding financial markets is different to scientific research, say in chemistry. Many scientific experiments can be repeated many times under controlled conditions to observe outcomes and hopefully understand the dynamics. But in financial markets, we don’t have this luxury of controlled conditions, .e.g we can't go back and repeat, say the 2000-2010 decade, under controlled conditions. Hence there is relatively more uncertainty in our understanding of financial markets.
This explains your comments on plumbers and medical professionals. Through, inter alia, repetition they have a relatively common understanding of their problem and how to fix it with a common set of “tools”.
In financial markets we are still at, and may remain at, the exploratory stage in understanding the markets, resulting in a range of beliefs.
However, a range of investor risk tolerances may also drive in a range of asset allocations under the same beliefs.

December 20, 2014

Could it be so simple that Voltaire described the problem in 1772 when he said “The best is the enemy of the good”?

Do people ‘try’ just that little bit harder to be better, and as a result form ever more complex and perhaps less effective strategies because they don’t want to accept ‘good’ results?

My brother is a fast jet pilot in the RAAF. His motto, which is also the squadron motto, is “excellence tomorrow” – which, he tells me, is meant to imply mediocrity today! If only the pursuit of ‘average’ was more wide spread.

Phil Brady
December 19, 2014

Yes, not sure why its taken 30 years! The myriad of false academic theories relating to the subject leads to a myriad of practices. And as Jerome above has stated its complex and dynamic. That said, a lot of the outcomes are random, therefore at best you can use a probability framework. But everyone's framework is structured differently and with various biases and the potential inputs vast. What's the answer? Always take precaution against the unknown unknowns, and the unknown unknowns happen more frequently than most models suggest!

Jerome Lander
December 19, 2014

Although it is not a new field, much of the training investors receive is based on false premises and a misunderstanding of the real world. Very little is evidence based or based on sound premises. In addition, the system is complex AND dynamic (constantly changing). Many investors then revert to what they trust and believe in personally, which results in many different permutations and effects such as an understandable bias for local assets with which investors are more familiar.

In addition, long term investors don't often work in a vacuum but in a social setting that influences their actions greatly. Investors' investment approaches are often influenced greatly by their first work experiences thus perpetuating biased approaches throughout their lifetimes.


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