Global Asset Allocation Perspective
Past Performance Really Is No Guarantee of Future Results
Fourth Quarter 2015
Senior Vice President and Senior Portfolio Manager
Asset Allocation Strategies
We’re calling for caution—not so much risk avoidance as a risk reassessment. Now is a good time to reevaluate risks in investor portfolios, and to think critically about strategies pursued in recent years. For example, markets have been volatile but essentially rising steadily since 2009. As a result, many investors have been trained to buy on the dips. But buying the dips doesn’t work as well in a sideways or declining market. This means that relying on a high-beta strategy in stocks, or holding stock-like bonds in your fixed-income allocation, is not likely to be as effective going forward as it has been in the past. Rather, we would argue for a well-diversified, risk-aware approach in both bond stock and allocations.
- In economic terms, we expect modest growth for some time thanks to a combination of higher interest rates, slowing corporate profit growth, and a strong dollar. In market terms, we don’t see a bear market, but we are seeing a classic sector rotation in stocks to late-cycle sectors and companies.
- We narrowly favor stocks over bonds, and within equities, we have eliminated our long-running bias toward growth over value-oriented stocks. We also feel that increasing volatility and decreasing correlations among individual equity securities has created an opportunity to add value via stock selection over pure beta strategies.
- In the fixed-income space, we expect interest rates will remain range-bound for the foreseeable future, as weaker global growth and currencies act as headwinds to the U.S. economy. As a result, we are neutral in our duration positioning. We continue to favor select spread sectors over nominal U.S. Treasury securities.
- As always, we think broad-based diversification (among and within asset classes, as well as geographic regions) and time in the market is essential to long-term investment success. Well-diversified investors, who are taking an appropriate level of risk in their portfolios, should be properly positioned to ride through the markets’ ups and downs.
For Want of a Fully Functioning Crystal Ball…
Forecasting the future is hard work. Nobel physicist Niels Bohr captured the spirit of the problem well when he famously said that “prediction is very difficult, especially when it’s about the future.” Desiring to know what lies ahead, many people take the seemingly reasonable step of looking around them and then projecting those same conditions forward in time. Upon reflection, it should be obvious that a rearview mirror is a poor substitute for a fully functioning crystal ball. Certainly, our friends at the Securities and Exchange Commission (SEC) have it right when they require asset managers to remind investors that past performance should not be misconstrued as being indicative of future results.
But despite these admonitions, investors do indeed project past results forward until and unless proven otherwise. This problem has very important implications for shareholder account balances, because investment performance is greatly influenced by behavior. Indeed, we can cite report after report—by Morningstar, Ibbotson, in the Financial Analysts Journal, among many, many others—showing that investors consistently buy past winners and sell losers (buy high and sell low), much to their financial detriment. In this context, it’s worth citing the work of market research firm DALBAR. For years now they have been evaluating retail investor performance to determine the efficacy of buy and sell decisions. Invariably their annual reports include these lines: “Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who time the market.”
What’s more, this phenomenon is not limited to retail investors. In the past we have discussed the fact that even savvy, institutional investors make asset allocation decisions based on three-and five-year track records; however, performance of financial assets tends to be mean reverting over the intermediate to long term. That is to say, a particular asset class or investment approach that has worked well for an extended period will typically then endure a period of underperformance relative to another style or type of investment. This disconnect between the timing of investor buy and sell decisions and market movements presents a serious hurdle for investors.
Uncertainty to the Fore
Armed with these caveats, let’s consider the current market environment. Monetary policy and financial market conditions have been remarkably consistent and supportive of risk assets since 2009. As a result, stocks stand in the neighborhood of record highs, bond yields are near historic lows, and growth-oriented stocks have outperformed value shares by a wide margin. In short, anyone forming a judgement about future conditions based on past performance, or a five-year track record, say, would probably conclude that risk assets are the bee’s knees.
In reality, however, we are concerned that investors lulled into complacency by favorable markets are likely to be ill-prepared for the risk and return profile of the major assets classes that we are likely to experience going forward. Consider that the Federal Reserve (Fed) is poised to begin a tightening cycle; the U.S. economy appears to be in the mid- to late-stages of economic expansion; global growth is tepid; European Central Bank monetary policy is highly dependent on economic and political developments in the eurozone; the U.S. is in the middle of a contentious presidential election cycle at home while beset with geopolitical challenges abroad; and the stronger U.S. dollar has a number of important implications for consumers, corporations, and investors.
Let’s choose just one of these challenges to discuss in more depth, and talk about currency for a moment. A stronger greenback makes U.S. goods more expensive for overseas buyers, so it is no coincidence that U.S. exports have suffered, particularly when coming at a time of weak global demand. In particular, manufacturing activity in the U.S. was just reported to be at the lowest level since 2009, when the economy was still in the throes of the Great Recession. Similarly, overseas earnings by U.S.- based multinationals are worth less when translated back into dollars. As a result, earnings growth for the companies that comprise the S&P 500® Index were negative in the second and third quarters of 2015. That’s the first time that S&P companies have experienced two consecutive quarters of negative earnings growth since—you guessed it—2009. Of course, a stronger dollar is beneficial for U.S. consumers, increasing the purchasing power of the dollar and keeping inflation in check, so it’s not all gloom and doom on this front.
Add it all up, and prevailing economic and market conditions suggest that the next five years are unlikely to look much like the last five. Reflecting this uncertainty, volatility in stock and bond markets rose sharply in 2015, reaching multi-year highs. What’s more, we think it’s likely we are in for even greater volatility going forward, rather than less. Admittedly, this forecast does not come to us by way of a fully functioning crystal ball, but it seems reasonable to suggest that indiscriminate risk-taking is not likely to work as well going forward as it has for much of the post-Financial Crisis period.
Example of Growth Versus Value
Having established the heightened degree of uncertainty and volatility in the market, let’s look at some examples of how this thinking is affecting our positioning. Our allocation to growth versus value stocks are a good place to start. These two styles of equity investing have routinely traded market leadership roles in the past. Today, we look back on an extended period of what is by some measures historic growth outperformance relative to value. Is it best to double down on growth, continuing to favor past winners? Our quantitative models now show only the slightest preference for growth, and given the recent performance disparity, we have just cut back our long-running growth overweight relative to value stocks. As a result, we are now neutral in terms of exposure by investment style in our asset allocation portfolios.
Asset Allocation in Action
To be clear, when we talk here about overweight and underweight positions, we mean in the context of American Century Investments’ own various, broadly diversified asset allocation portfolios. For individual investors, whether you build your own portfolio of uncorrelated assets or do so with the aid of a financial professional, your own portfolio is likely to be a unique reflection of your own goals, risk tolerance, and other life cycle and financial considerations. The key point is that effective diversification has the potential to mean better risk-adjusted performance; a less volatile return pattern; better cumulative returns over time, other things equal; and greater likelihood of sticking with an established investment plan. We believe that is a strategy worth striving for.
Finally, a diversified approach can actually improve the timing of investor buy and sell decisions as a result of the process of portfolio rebalancing. Step back for a second and think about diversification—at a high level, it’s a process of spreading assets within and across asset classes in a way that is likely to maximize your likelihood of sticking to your investment goals and objectives over time. You (or your financial professional) create a well-thought-out strategy weaving together all the aspects of your financial life to create a finely tuned, broadly diversified portfolio.
But as financial markets move, those carefully selected asset weightings and relationships get out of balance with your intended targets. Putting those weightings back in balance is called “rebalancing,” in which you sell winning assets and buy those that have underperformed. But after a long risk rally, equities are likely comparatively overrepresented because they’ve done so well, while other asset classes are likely to be underrepresented relative to the weightings targeted in your original diversified portfolio. Rebalancing to predetermined weightings would mean you were selling stocks and other risk assets after an historic rally and buying other, less favored assets classes during the big risk rally. The contrast with investor behavior cited in the DALBAR and Morningstar studies could not be more stark. In no uncertain terms, then, systematic rebalancing enforces a disciplined buy-low, sell-high strategy that is central to a sound investment plan.
Bond Market View
Our fixed-income team publishes their global macroeconomic and market view in the quarterly Fixed Income Macro Outlook, on the American Century Investments website. It makes excellent reading for those eager to understand the current state of the global economy and fixed-income markets. They put forward several key themes for 2016—modest U.S. economic expansion in the face of a global drag on growth and inflation, a normalization of Fed monetary policy, and further strengthening of the dollar. This continued divergence between the U.S. and much of the rest of the global economy and financial markets informs the fixed-income team’s positioning across countries and bond market sectors.
Global Equity Outlook
Our global equity team does not make explicit sector our country bets. Rather than take a top-down view of economies and markets, they rely on a bottom-up, individual stock selection process. They believe this necessarily produces a more diverse portfolio reflecting many individual security selection decisions, rather than one or a few top-down, macro decisions. As a result of this process, they currently are finding significant opportunities in the U.S. and Europe, where they hold overweight positions, while holding underweights to Japan and commodity-exporting countries, such as Canada, Australia, and New Zealand. You can access the global equity team’s latest views in the quarterly Global Equity Outlook online.
Our latest detailed economic analysis and fixed-income outlook is available on our websites in the form of the Fixed Income Macro Outlook.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of American Century Investments (or the fund manager) and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.
For detailed descriptions of indices or investing terms referenced above, refer to our glossary.
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