Andrew Möller, Director and Chief Executive Officer, Citadel
One of the oldest debates in investment circles is whether asset allocation or stock selection is the main driver of portfolio performance. As with the active versus passive debate, however, any successful investor will have realised by now that it is foolish to be in either camp, or that it is far wiser to utilise a combination of both within your investment strategy.
For example, if you were to take a sample of multi-asset funds, the chances are very good that both the best and worst-performing funds would each have a high equity allocation. This would suggest that the difference in these funds’ performances is attributable to the choice of specific stocks rather than the differences in the asset managers’ allocations to cash, bonds or equities.
Next, consider the differences in portfolio performance between two of the main ASISA fund categories, namely the SA General Equity and the SA Multi-Asset High Equity categories.
SA General Equity portfolios must hold at least 80% of their investments in JSE stocks, implying that performance should mainly be driven by stock selection. SA Multi-Asset High Equity funds are constrained by Regulation 28 limits on equity and offshore exposure, but managers can greatly vary their asset allocation within the set limits, as well as make active stock picks.
Examining Morningstar fund data from the five years to the end of March 2019, the best performing equity fund delivered average annual returns of 11.2% and the worst-performing -2.2%, compared to the best-performing multi-asset fund at 10.5% and the worst-performing at -1.1%.
This suggests that the cross-sectional distribution or variation in fund performance in equity funds is greater than multi-asset funds, further supported by the table below:
Table 1: Cross-sectional distribution of five-year total returns
|Measure||Average Return||Standard Deviation||Percentile Returns|
|SA General Equity||4.5%||2.3%||1.0%||3.0%||4.6%||6.1%||8.0%|
|SA Multi-Asset High Equity||5.8%||1.6%||3.5%||5.1%||5.8%||6.6%||8.7%|
Source – Morningstar; Data – Monthly for the five years ending 31 March 2019; annualised.
This simple analysis then points to the fact that stock selection can indeed be the main driver of performance, or at least return variability.
However, the table also clearly highlights the fact that over the past five years, the average SA Multi-Asset High Equity fund outperformed the average SA General Equity fund, mostly owing to multi-asset managers’ ability to allocate to global equities.
Consider, for instance, that over the past five years the FTSE/JSE All Share Index delivered average returns of 6.5% per annum, while the BEASSA All Bond Index achieved returns of 8.3% and the MSCI AC World NR Index achieved 13.4% in rand terms. Given the broader context of a South African economy that has continued to struggle while the rest of the world has experienced above-trend growth, investors’ need for offshore exposure has been undeniable.
Furthermore, by making stock selection the key driver of performance, investors are likely to increase the risk and return variability of their portfolios, making their final investment outcomes far more uncertain.
Choosing asset allocation as the main driver of performance
At Citadel, we therefore choose to make asset allocation the main driver of portfolio performance, structuring our solutions around the strategic asset allocations that over time are expected to deliver on each of clients’ investment objectives.
Strategic asset allocation is, in our view, by far the most important decision an investor can make, and is one of the four pillars of our investment philosophy.
Following this, the crucial next step in the investment process should be tactical asset allocations, or judging where to deviate from the strategic asset allocation and increase the weighting of asset classes with superior expected returns.
In the 12 months to the end of March 2019, for example, global listed property, or the MSCI World REIT NR Index, returned 42% in rand terms, and most of our clients were able to benefit from our tactical decision to hold this asset class.
Further, as we approach the end of a decade-long global bull market, our asset valuation models indicate that equities may potentially deliver slightly less attractive returns. We are therefore reducing risk in our portfolios in order to limit volatility and capital loss, especially for those clients who draw an income from their portfolios.
The final decision in the investment process should then be selecting specific stocks or funds.
As already demonstrated, stock selection can impact performance, and equity portfolio managers could possibly construct a portfolio with the ability to substantially outperform the benchmark by concentrating the portfolio in certain shares or sectors, or by taking liquidity or specific-factor risk.
However, we believe that taking on these risks is not in a client’s best interests in the long-term. Active positioning relative to the index should only be taken to the degree that value can be added on a risk-adjusted basis.
Ultimately, both asset allocation and stock selection therefore play an important role in long-term performance, and the real question is rather which one investors should choose to determine your portfolio’s performance.
And, to our mind, correct asset allocation, especially for South African investors, can produce a diversified portfolio with lower risk, better potential returns and greater certainty in terms of outcomes, increasing the likelihood of meeting your investment objectives.