We have added weightings to convertibles within the annual strategic asset allocation (SAA) for the Liontrust Multi-Asset portfolios for the first time. There is now a 10% allocation to convertibles in the low and medium-risk SAAs because of the different risk/return profile these debt instruments offer.
This is the most significant change implemented as part of this year’s SAA review. The weightings to equities, bonds, cash and alternatives have moved by small amounts but are broadly the same as in 2020.
The other key development is the fact that volatility spikes seen in 2020 following the outbreak of Covid have dropped off. This means volatility on the portfolios remains at the lower end of risk ranges in line with prevailing depressed levels of recent years.
Before we go into the detail of this year’s SAA review, we will summarise how we conduct it and why it is the first stage of our Multi-Asset investment process.
How we determine the SAA
A key part of our investment philosophy for the target risk Liontrust Multi-Asset portfolios is that successful fund management combines elements of art and science.
The SAA is a clear scientific element and is designed to enable each portfolio to achieve its target risk level. Broad correlations between asset classes tend not to change – equities are higher risk than bonds, for example – so if our underlying assumptions are correct, our SAA is unlikely to move much year on year.
What we do get over time is more information on correlations and volatility and we continue to evolve the SAA in line with these. Working with Liontrust’s risk team, we collate and analyse the historical returns and volatilities of a range of asset classes, as well as their correlations with each other, to determine the best SAA for each model portfolio to meet its volatility target over the long term.
Volatility
Looking at the annual SAA for 2021, despite obvious spikes amid the initial fallout from the pandemic, volatility has dropped off again and our numbers continue to reflect the lower levels of recent years. Volatility has been beneath long-term averages for more than a decade, depressed by the quantitative easing that began in the wake of the global financial crisis and has continued, in one form or another, ever since.
More recently, there have been growing concerns about inflation picking up and central banks beginning to taper their asset purchases, which may feasibly see volatility pick up. While this may mean changes to our SAA when we review the position next year, we would still not expect anything too substantial given we analyse long-term data.
While volatility has been lower for several years, we are not tempted to chase either risk or the market itself, both of which can lead to a risk spike in the short term and potentially higher drawdowns. As our investors know, the Multi-Asset investment process is built on the foundation of winning by not losing over the long term through focusing on downside limitation before upside generation – and chasing risk obviously runs counter to this.
Whenever we discuss SAA, it is important to reiterate any moves are not tactical but rather reflect how the data dictate we can best achieve our volatility targets, with the changes representing underlying shifts in the risk and return profiles of asset classes. Ongoing market upheavals due to Covid-19, and rising concerns about high inflation for example, provide an opportunity to highlight what SAA is and, as importantly, what it is not, particularly relative to peers who move their strategic allocation around more aggressively.
SAA is our allocation should we have no views on the relative attractiveness of asset classes; this is the middle lane of the motorway if you will, or the route selected to get to our ultimate investment destination. Where we can add value and take advantage of cheaper valuations is via tactical asset allocation (TAA), and how we select funds to implement our views. To continue our analogy, this is where we can move into the fast or slow lanes when it makes sense to do so.
2021’s SAA
We produce low, medium and high-risk allocations, equating to portfolios 3, 6 and 8 in our 1-10 range of risk profiles.
Like last year, headline changes as part of the 2021 review have been fairly small, and overall allocations to equities, bonds, cash and alternatives are broadly similar to 2020.
The most significant difference is the addition of a 10% allocation to convertibles in the low and medium-risk SAAs, an asset class that offers a different risk/return profile thanks to options built into these debt instruments to convert to equity at a predetermined strike price.
This means convertibles can be used as a hybrid, offering equity and bond characteristics; they provide regular income and return of capital at the end of a fixed term like traditional bonds but with an option to convert into a certain number of shares, allowing holders to participate in share price rises while retaining a degree of bond-like protection against market falls.
Liontrust’s acquisition of the Architas UK investment business last year has expanded the Multi-Asset investment team and given us further resources to analyse a broader set of asset classes. Now convertibles are included in the SAA, we have expanded the research remit to assess the suitability and availability of funds investing in this part of the market.
Within equities, the UK allocation has fallen again in the low and medium-risk models, although we do see opportunities in this market on a tactical basis after it was among the worst hit last year. The allocation to UK smaller companies has also fallen on the medium-risk SAA but this is down to a call to shift UK small-cap decisions towards the tactical part of our process – where we can add more value – rather than any change in risk profile. With US smaller companies, the allocation has increased in the medium-risk SAA.
Elsewhere, the allocation to the US moved up on the low and medium-risk SAA while Japan and emerging markets ticked up slightly on the latter as Europe and Asia fell.
Within bonds, developed market government exposure fell on the low-risk model again, as did high yield, with this allocation shifting into the new global convertibles category. The high yield and emerging market debt allocations also dropped on the medium-risk SAA. Finally, for the alternatives allocation, only represented in the medium-risk SAA, hedge funds and commodities both fell while property and absolute return remain at zero.
To reiterate, there is no tactical element to these changes but given the investment process is designed to produce the optimum basket of assets in terms of risk/reward to meet volatility targets, the moves will often chime with our tactical thinking.
As part of our latest target TAA review (ranking asset classes from one to five, with five the most bullish), we pared back our stance on Japanese equities slightly, moved more positive on UK smaller companies and neutral on the US (from 2 to 3), and are slightly more constructive on UK gilts and global government bonds.
Japan is still among our favoured cheap equity markets and we feel the country, with its high proportion of old economy cyclical and value stocks, is well positioned amid the ongoing global reflation trade. We moved our target TAA score down from five to four, however, on concerns about the country’s slow progress on Covid vaccinations, which could impact domestic recovery in the second half of this year.
For UK smaller companies, we moved from three to four as the recovery continues, with predictions claiming the economy will grow at the fastest rate since the Second World War this year, based on a cocktail of successful vaccine rollout, pent-up demand being released, and ongoing fiscal and monetary support. A strong rebound in UK small caps is already under way but there is further scope for mean reversion with Brexit uncertainty disappearing, sterling normalisation and M&A activity.
As for the US, our long-standing concerns about valuations remain intact, especially at the more speculative tech end, but 2021 earnings have surprised on the upside and the market is starting to offer better value after a recent cooling off. The key question remains whether the US is prone to a deeper correction after the great acceleration of the last year. A shift towards ‘real world’ rather than virtual interaction as the world opens up will put further pressure on technology revenues and share prices have already discounted those better-than-expected earnings.
Finally, we moved gilts and global government bonds from one on our scale up to a two: while still towards the more bearish end, this reflects bond yields grinding upwards over recent weeks on the back of inflation concerns and looking slightly more attractive.
