Asset allocation isn't everything. The next step matters, too

Article content

Most market practitioners agree that asset allocation is likely to be the largest driver of long-term portfolio returns.

If asset allocation is indeed Step 1A in portfolio construction, then the way you receive returns from that asset class is equally important. Let’s call it Step 1B.

Some asset classes, or exposures, can be reasonably received as beta, via an index fund or exchange-traded fund. Other returns can or should be delivered via a specific strategy. A GARP, or Growth at a Reasonable Price, equity fund might be a good example.

The optimal way to gain exposure to certain asset classes – the low-volatility and high-return investment grade credit asset class, for instance – is through the expertise of an active manager who has the tools, access and experience to deliver 1A most effectively, via their proven 1B strategy.

Select Canadian credit managers can provide 1A – fixed income – through their 1B credit fund, where certain expertly managed funds delivered more than an 11-per-cent return in 2023, outperforming the fixed-income benchmark by more than 5 percentage points with lower standard deviation. In this example, 1A is fixed income, and 1B is an investment-grade credit fund providing the additional 5 per cent of outperformance.

Think of 1A/1B like the difference between a good and bad haircut. Once you determine that you need a cut you still need the stylist. Similarly, choosing just the right restaurant for a great steak. Will that new car be EV or gas, Mazda or Maserati? If you’re going to do it, do it right, for you.

I believe that parts of the investment industry have done investors a disservice in their effort to scale businesses while stripping costs. Even for investors who select asset classes (1A) effectively, the proliferation of index investing – proposed as an easy, one-stop, low-fee portfolio solution – has not held up when scrutinized for long-term, after-fee returns. Index funds may accomplish the low-fee promise, but they usually fail to produce optimal portfolios for the risk taken, or optimal returns for well-chosen asset classes.

Investors may need to be reminded that low fees are great, and benchmark returns may sound appealing, but absolute returns – after fees, within appropriate risk parameters that meet or exceed portfolio target returns – are the ultimate goal. The optimal portfolio likely includes index-type funds, as mentioned above, but it highly likely also includes dependable, active asset management partners as well. 1B matters.

Effective active asset managers, who have proven the ability to optimize the delivery of an asset class (1B), make a host of informed choices to manage your investment. They are guided by a dashboard of signals, they establish access to the best investments in the most effective formats, they own and develop tools to manage and deliver the portfolio, they perform essential relative value assessments, et cetera, to deliver optimal exposure to an asset class or a particular strategy. They do this consistently, through market cycles, in ways that most of us, or indices, cannot.

Good active managers are experts in their asset classes who have proven to stay on style, within the parameters of their stated investment strategy. What I find most compelling about truly good active managers is their ability to dial exposure and risk levels up as opportunities arise, and to be defensive within their asset class as required, as opposed to a constant static position within an asset class. I think that is where good asset allocation and good manager selection shine, and I expect the good active managers will outperform in 2024.

As a case in point, our firm took a defensive outlook last year and still expects a recession in Canada, yet the portfolio managers found liquid, low-risk ways to produce effective return within our investment-grade asset class. In fact, the risk level in our credit funds was at its lowest in several years in mid-October before various inputs signaled a compelling shorter-term opportunity to add risk through year-end. 1B made a meaningful difference during several periods of 2023.

1A without effective 1B, especially in volatile markets that are experiencing historically meaningful dispersions between names, sectors, tenors and asset classes, is not an optimized investment and will fail to maximize total portfolio benefits.

Private equity is another good example of a popular source of alpha and absolute return for many portfolios. However, if you smartly chose PE as an exposure (1A) but you did not choose one of the top-performing PE funds (1B), then your portfolio probably missed out. A 2022 Nasdaq eVestment report states that “the spread between the top and bottom quartile funds in private equity is a whopping 12.9 percentage points compared to 1.5 percentage points for public equity funds.”

As mentioned above, perfecting 1B in portfolio management likely includes low-cost solutions, too. Gaining exposure to the S&P 500 Index is probably best accomplished through a low-fee ETF or mutual fund because history has shown that so few managers consistently outperform the S&P equity index. Portfolio management is all about total return, over time, within chosen risk parameters, after fees. The best investment managers select the right mix of fees and solutions that optimize expected returns after fees.

When searching for the right asset managers for your chosen asset class or exposure, I suggest you look for the ones who can demonstrate the insight, tools, experience and discipline to maximize total risk-adjusted returns, not only absolute returns. Typically, the best active managers deliver high Sharpe ratios and protective down capture stats, with lower standard deviation than their benchmark. These managers often produce better drawdown experience, low correlation to other asset classes, and high break-even levels, which all help to reduce total portfolio risk. High long-term returns along with these risk-reducing attributes is the holy grail of investing, and it requires the best coordination of 1A and 1B.

Consideration of the manager performance statistics above has proven valuable in choosing specific investments. In my experience, this type of due diligence has allowed many good investment managers to better evaluate expected future returns with a more complete data set than solely historical returns. In fact, historical returns on their own can be out of context and will often lead to a sub-optimal, yet crucial, 1B investment vehicle/asset manager choice.

Every investor covets high, long-term returns, but I find the most successful investors optimize portfolios by prioritizing the compelling risk-adjusted expected returns from the right source. The successful ones choose the 1A asset classes well, while they plan the 1B implementation and delivery decisions at the same time. They coordinate asset classes and vehicles, exposures and sources, risk and return – 1A and 1B.

Kevin Foley is a managing director, institutional clients at YTM Capital. YTM Capital is a Canadian asset manager focused on “better fixed-income solutions,” specializing in credit and mortgage funds. Kevin is the former head of credit trading and fixed income syndication at a major Canadian bank. He sits on three Canadian foundation boards and investment committees.

Please visit here to see information about our standards of journalistic excellence.