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Bespoke market insights from our CIO

01.02.2021

Active asset allocation wins in 2020

2020 was a year of extremes. In society and in the environment the extremes were clear. In financial markets, there were extreme winners and extreme losers. Afterpay rose an incredible 303% over the year while Flight Centre dropped 60%. The extremes were even greater in the US where Tesla rose 743% while cruise line company Carnival fell 57%. Extremes were also evident at the macro level. Within the space of just one year Australia recorded its deepest recession since records began 61 years ago as well as its fastest recovery. Households were blessed with the highest saving rates in more than 60 years (22.1%) but cursed with the lowest term deposit rates in history (0.35%).

2020 was also interesting from a whole of portfolio perspective. Academic research tells us that the most important decision an investor can make is their strategic asset allocation. That is, the mix of equities, bonds, property and cash. More than 90% of the variation in your return comes from this decision alone. Other decisions, like manager selection and tactical tilts make up the remaining 10%. 

Looking back on our own performance, using our own list of managers that we have selected and our own tactical decisions that we implemented we arrive at a similar result.

Over a 5-year investment horizon, we find that almost 90% of an investors’ return (86.2%) came from the strategic starting point (the strategic asset allocation). An additional 9.9% came from the choice of managers. The remaining 3.9% came from tactical tilts.

Enlarge Source: Escala Partners, Bloomberg as at 31/12/20

This result begs the question. Why devote resources to manager selection and tactical tilting if so much of the return comes from your strategic asset allocation? The answer is because there are times when manager selection and tactical tilts matter. 2020 was one of those times.

The second pie chart shows the same analysis but looking just at the year 2020.

Enlarge Source: Escala Partners, Bloomberg as at 31/12/20

Over the last year, just 36.8% of the total return came from strategic asset allocation. A hefty 40.0% came from manager selection and a sizeable 23.2% came from tactical tilts.

What can we conclude from this?

First, it is clear that for long term investors your strategic starting point is the most important decision you will make when it comes to your investment portfolio. A second conclusion however is that there will be times when you will value active manager selection and tactical tilts. Much like insurance, most of the time you will not notice it – it just functions away in the background. But there are occasions when you do need it and are glad to have it. To borrow from a well know insurance slogan, 2020 was one of those years where “it paid to belong”.

Depending on where you are in your investment journey, a poor year of returns can have a big impact. A passive portfolio (with no manager selection or tactical tilts just passive ETFs) generated a return of just 4.2% last year*. Our manager selection lifted that return to 8.8% and our tactical tilts added a further 2.7% taking the total return for our “Capital Growth” option to 11.4% for 2020. Compound 4.2% over 10 years takes a $100 investment today to $151 in 2031. Compound 11.4% and your $100 grows to $294 in 10 years time.  The difference is almost double.

We don’t expect to make big calls on manager selection or tactical asset allocation every year – that is not what we are about. But there are times when there are clear opportunities to either add value or protect value. Being allocated to a growth biased fund manager was the right decision last year (a well-known value manager generated -7% while our preferred growth manager returned 6.8%). It added considerable value. Moving to a currency hedged international equity position when the Australian dollar fell to 57 US cents in March was also the right decision. It protected considerable value. 

Whether we need to make these kinds of decisions this year or not we don’t know – we have no foresight on that. But having the processes and team in place to monitor and oversee manager and tactical decisions means we will be ready to act if the need arises.  

At Escala, we believe in the importance of setting the right strategic asset allocation. But we also believe in the benefits of prudently selecting and overseeing manager selection and on occasion tactically tilting away from the strategic setting when there is a clear investment reason to do so.

*analysis is based on a “Growth” portfolio where 80% is allocated to risky assets like equities and 20% to bonds and cash. Returns are after fund manager fees.

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