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The Markets October 27, 2011
Paper Suggests Asset Allocation Adjusted to Inflation and Growth
Investors who dynamically adjust asset class exposures as growth
and inflation expectations shift may significantly improve risk-adjusted
returns, according to a white paper from BNY Mellon.
Reported by Rebecca Moore
Published by BNY Mellon Asset Management’s Investment Strategy and Solutions Group (ISSG), the paper contends that a back-tested portfolio of asset allocation adjustments based on growth and inflation expectations has achieved nearly a doubling of the risk-to-return Sharpe ratio (a higher Sharpe ratio implies a higher return for the same amount of risk) over the last 23 years, when compared with a typical institutional portfolio.
The report, “Great Expectations: Regime-Based Asset Allocation Seeks Higher Return, Lower Drawdowns,” says this approach to asset allocation may also provide meaningful downside
protection in periods of market stress, such as the bursting of the
technology bubble in the early 2000s and the global financial crisis of
2007-2009, the report said.
The ISSG report concluded that
growth and inflation expectations in the U.S. over the last 40 years
included a more complex pattern of macroeconomic regimes and transitions
than many investors assume. Changes in growth and inflation
expectations rather than simply changes in growth or inflation
significantly can affect asset class performance, according to the
report.
The group used these insights to develop a model to
predict the probability of regime changes and adjust portfolio exposures
accordingly. “We think asset allocation approaches that are mindful of,
and responsive to, portfolio risk factors across regimes have the
potential to achieve investors’ long-term return objectives, while
better protecting against devastating drawdowns,” said Jeff Saef,
Managing Director of BNY Mellon Asset Management and head of ISSG. “Given the challenging investment environment, we believe
investors should consider a more opportunistic approach to asset
allocation strategies.”