Looking back on a decade of objective based investing

On October 1 the Schroder Real Return strategy will be 10 years old. When it launched, we were in the eye of the GFC storm — market volatility was extreme, liquidity had collapsed, and investor confidence had been decimated. Ten years later and you could be excused for wondering what all the fuss was about. Market volatility is low, central banks continue to provide liquidity, and investor confidence – particularly with respect to US stocks – is high. We’re certainly wondering when the bull market will end. In another 10 years it will all be clear, but right now we can only guess … and stick to process. I’ll come back to this point later.

When we launched the Real Return strategy 10 years ago, our aim was to reshape the way we thought about, and constructed, portfolios. Our primary goal was to shift focus away from trying to “add value” against a strategic asset allocation (SAA), and instead focus purely on constructing a portfolio to achieve our clients’ objectives — typically defined as a decent “real” rate of return, moderate volatility, and preserving their capital in times of significant drawdown.  This was one of the first “objective based” multi-asset fund in Australia.  We wanted investors, irrespective of when their investment commenced and/or the timing of their cash-flows along the way, to get a similar experience, aligned with these relatively simple, fundamental objectives. It is an old investment saying, but you can’t “eat” relative returns and the GFC was a great reminder. What we owned and when we owned it was key.

We also knew this task would not be easy. We were challenging convention and had nowhere to hide. Unlike typical asset allocation frameworks, where the SAA is the benchmark (or in single asset class portfolios where there is a benchmark portfolio), there is no “neutral” or “risk-free” portfolio we can default to that will deliver us our objective. “All” decisions would in effect be “active” decisions and require a necessary trade-off between potential returns and the risk of being wrong. A forward looking and unconstrained framework was risky and even if we achieved our objectives there would always be an opportunity cost, as on any given day, by definition, something would be performing better than the portfolio — equities in a bull market, bonds in a bear market.

We were, though, sure of two things: the investment process would be critical to the achievement of our objectives over the long term, and that we would inevitably make mistakes and learn a lot along the way.

Ten years down the track and my belief in the importance of process has been reinforced. That’s not to say our process has been perfect. It certainly hasn’t predicted every wobble (or lack thereof) in markets, and more recently it has steered us away from risk assets too early. But it has provided us with a roadmap by allowing us to systematically process and interpret information in a way that aligns with our investment beliefs, ensuring we’re at least heading broadly in the right direction. It’s also helped our clients understand what we do and how we’re responding to different environments. Perhaps most significantly, it’s also helped us more clearly identify where we need to improve. 

On this point, the biggest challenge we’ve had has been reconciling deteriorating asset valuations with the deep and seemingly limitless pockets of central banks. Our value focus has caused us to lean against risk in most assets, while the challenge of assessing output gaps (and hence inflation risks) has made it difficult to identify the triggers to which policy makers would need to respond. Growth, in the absence of inflation, has allowed the party to roll on. At the same time the collapse in volatility significantly tempered (temporarily) the contribution active asset allocation could make. Volatility creates opportunity, and over the last couple of years there hasn’t been too much of this.

But, the cracks are appearing. Seemingly bulletproof assets like Sydney house prices are falling, and while volatility may still be exceptionally low in the US equity market (as it records its longest bull market), other markets are finding the going tough. For example, emerging market equities (in USD terms) are down around -20% from their January highs, the Australian dollar is down -12%, and the Facebook share price is down -25% from its highs. Who would have thought?

This proves what goes up can come down, particularly if it disconnects from fundamentals. That said, we are in the later stage of this market cycle. While the US economy is doing well, the fact that US inflation and wages are now rising means it is overheating. Monetary policy will need to continue responding. This, plus the economic policy uncertainty presented by President Trump, particularly with regards to the highly political tariff war with China (amongst others) is a significant contributor to rising instability outside the US.

While we can’t go back in time and add risk to capture past gains, the flip-side of shedding risk (even if too early), is that it does leave us relatively well positioned should these trends broaden. Likewise, the realignment of monetary policy and key currencies are important return opportunities for us in the near term. Asset allocation is back (not that it really ever went away), but if market conditions are starting to turn, then the assets we own and how much of them will the critical decision once again — just as it was before, during and after the GFC.

It is true to say that investors in recent years would have achieved higher returns in balanced funds than via an objective based approach like ours – given the strength and persistence of (primarily) the US equity bull market. Our own Schroder Balanced Fund has, for example, delivered higher returns over the last three and five years then the Real Return (CPI+5%) strategy. The odds of this persisting though are lengthening. While history doesn’t repeat, it does rhyme, and with risk pricing distorted (just as it was in 2006 and 2007), the arguments in favour of a more flexible approach are strong.

So, have investors learnt anything in 10 years? It’s hard to say! Those that have backed central banks have done well so far. But these are the same central banks that have pulled the monetary levers for many years and presided over some quite significant policy mistakes and precipitous declines in share prices. Even if this cycle doesn’t end with a bang just yet, the risks are rising.

Navigating the next 10 years will, I suspect, be no easier than the last. That said, we have 10 years more experience to draw on. Hopefully that stands us in good stead.