Should we be thinking about investment differently in 2021? Certainly, there appears to be cause for challenge of current thinking on inflation rates and the rise of China in the new world order. There is also room in our view for more capital-efficient liability-driven investment and greater diversity of investments with more downside protection.
But the opportunities also extend to the nature of investing and different ways to approach it that may support better outcomes.
Until recently the strategic asset allocation (or SAA) approach to portfolio construction has been the norm for almost all institutional investors. But this is no longer the approach that many of the world’s largest asset owners in the world (including us in our delegated portfolios) follow. In recent years we have seen the rise of what is being termed the ‘total portfolio approach’ (TPA). TPA reflects a more bottom-up approach to portfolio construction than the top-down SAA approach, where each individual manager (or underlying asset) opportunity is considered in terms of its impact on the overall portfolio. There is genuine competition for capital against all the other opportunities, not just the other ones in that asset class. TPA is also increasingly being seen as the only way to truly integrate new risks such as I&D and climate. Learn more about TPA.
The Active / Passive debate
Controversially, we are of the view that a passive approach within equities is now more risky than many active approaches. How on earth can passive be more risky than active when it is so diversified by the number of stocks? Well, there are two key reasons. Firstly, concentration. 40% of the US equity market is now made up of technology companies, almost identical to the weight in the dot.com bubble of 2000. But perhaps more pertinent is the fact that 22% of the entire S&P500 is made up of just 5 companies – which all happen to be technology stocks – the most concentrated the market has ever been in history. That is not to say that all active approaches own less in technology today, or indeed in those 5 companies, but they are certainly not forced to by their mandate.
Now for the second reason why a market cap passive approach is risky – climate change. The global public equity market is made up of a lot of large, ex growth companies with legacy carbon intensity issues, and this is a problem that is getting worse as more and more successful private companies decide to stay private for longer; in a less capital intensive economy dominated by services these companies no longer need to go to the stock market for capital, and at the same time they can get capital in other ways. Carbon intensive companies are under ever increasing pressure from regulators and shareholders to act and it is being reflected in prices.
Taking the concentration and carbon intensity risks together it is fairly clear that the old assumption that passive is lower risk than active is in many cases false. We would encourage clients to think about any market cap passive exposures they have and consider a move to either tracking a better designed index or adopting a fully active approach.
Simple equity/bond approaches have worked very well during a falling rates regime, but we contend that this is unlikely to be the best approach from here. 2021 needs a portfolio that is necessarily more complex to make the most out of the opportunities available and manage your risk.
This year, our top priority areas for investors to consider in their growth assets portfolio are as follows:
- Increase the exposure to real assets
- These offer both diversity and some inflation protection
- More private equity and less public equity – with more of the world’s great growth companies staying private for longer, there is even greater scope for private equity to outperform public equity and it also looks lower risk for some of the reasons mentioned already
- Increase your exposure to China – at least initially through China A shares, but we also think a multi asset approach is warranted
- Revisit the use of active management – good quality active management should help mitigate risks, such as index concentration, but we also believe there is increased opportunity for managers to add value as there is likely to be greater dispersion between different sectors and countries in the COVID recovery
- Consider low risk bond substitutes - this could include secure income alternatives, hedge funds or even Chinese bonds