Investors who dynamically adjust asset class exposures as growth and inflation expectations shift may significantly improve risk-adjusted returns, according to Great Expectations: Regime-Based Asset Allocation Seeks Higher Return, Lower Drawdowns, a white paper from BNY Mellon Asset Management's Investment Strategy and Solutions Group (ISSG).
A back-tested portfolio based on ISSG's methodology that adjusted allocations according to changes in growth and inflation expectations over the last 23 years 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), when compared with a typical institutional portfolio, according to the report. This approach to asset allocation also may 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.
"We think the current environment of modest expected market returns and heightened volatility requires a fresh look at asset allocation approaches," said Jeff Saef, managing director of BNY Mellon Asset Management and head of ISSG. "The financial crisis taught painful lessons about the limits of traditional diversification and the need to achieve a deeper understanding of the macroeconomic influences on asset class performance and correlations."
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 Saef. "Given the challenging investment environment, we believe investors should consider a more opportunistic approach to asset allocation strategies."
By drawing on BNY Mellon Asset Management's global network of investment boutiques, the Investment Strategy & Solutions Group (a part of The Bank of New York Mellon) seeks to deliver solutions to meet the specific needs of corporate and public retirement plans, endowments and foundations, sovereign wealth funds, financial institutions and intermediaries.