Embrace risk in asset allocation

Investors should be wary of “new paradigm” arguments, according to the latest research by consulting firm Wurts & Associates, which reminds investors the forces driving capital markets rarely change, but the position within market cycles is ever changing.

Wurts & Associates’ philosophy on strategic asset allocation is that static portfolio structure is an ineffective means of managing risk and achieving return goals.

“So we believe that dynamic portfolios are necessary. The challenge of course is judiciously responding to changes in capital markets while avoiding fruitless market timing activities.

“Because capital markets conditions are ever changing, our opinions will be ever changing as well, meaning the markets dictates the pace of change of asset allocation policy, not any arbitrary timeframe.”

According to Wurts the cycle of capital markets falls under four stages, with the current conditions defined by a flight to safety as well as economic stimulus, forming the beginning of the cycle.

Capital markets then move into a phase where investors tip-toe into risky assets, the economic stimulus works, with high grade investments recovering first; before moving into a phase where a flight to risk ensues, real estate, equity and credit markets rise, and household balance sheets are repaired.

The final stage of the capital market cycle, which Wurts tentatively predicts will be 2019, is characterised by overvaluations and overconfidence, where downside risks abound and are ignored, and liquidity triumphs over reason.

“Whether or not we have seen the worst of the bear market clearly remains to be seen. Objectively speaking though, both history and an analysis of the fundamental forces driving capital markets may portend we have seen the bulk of the downside,” the research says.

“Without a doubt our largest concern for institutional portfolios is the risk of a strong resurgence in inflation. We cannot foresee likely scenarios by which inflation falls within currently implied levels over the next decade.

“When viewing both equity and credit investments through a 10-year time horizon, we are facing the most attractive risk adjusted returns in decades.”

With this in mind Wurts highlights a number of asset allocation implications: embrace risk in equities and credit markets; favour US large cap over US small cap; look at international equities and emerging markets (according to MSCI, US equities are the most expensive in the world); and high yield and corporate investment grade bonds, mortgages and illiquid credit.