This article first appeared in Forum, The Edge Malaysia Weekly on March 20, 2023 - March 26, 2023

Large pension funds such as our Employees Provident Fund (EPF) or sovereign wealth funds such as Norway’s Government Pension Fund Global have been using asset allocation strategies to manage money.

Paraphrasing the meaning of asset allocation from Investopedia, in short, it is the process of deciding where to put money to work in the market. Investors usually apportion a portfolio’s assets in three main asset classes, such as equities, bonds and cash and equivalents. The aim is to balance risk and reward. 

A basic rule is that diversification is the key to asset allocation, and it is critically important to have assets with low or negative correlation. While one asset class underperforms, you would like to see another asset class outperform. For instance, in a stock bear market, you may see your stocks go down, but your bonds tend to offset that.

The venerable and conventional asset allocation strategy is the US 60%/40% portfolio (60/40 portfolio). In short, investors allocate 60% of their money to US large cap stocks (S&P 500 index) and 40% to US bonds (Bloomberg aggregate bond index).

From 1976 to 2021, the US 60/40 portfolio fared well, with an annual return of about 10% amid low volatility. It worked well mainly because of the negative correlation between the two assets. As stocks go down, bonds go up.

Most pension funds and sovereign wealth funds have mirrored their asset allocation strategies along the lines of the conventional 60/40 portfolio with some tweaks. 

For instance, EPF allocated about 44% of its portfolio assets to stocks and 45% to bonds in 2021. The widely hailed US$1.2 trillion Norwegian sovereign wealth fund has about 72% of its total investment in global stocks, 25% in global bonds, and the rest in real estate and renewable energy infrastructure.

In short, many pension funds and sovereign wealth funds are stock- and bond-centric. However, the correlation is not static.

In 2022, the conventional US 60/40 portfolio did not fare well and suffered a loss as both asset classes went down together. This is due to the positive correlation between the two assets because of high inflation.

Bonds used to provide protection against stock sell-offs such as during the global financial crisis in 2008 and Covid-19 crisis in 2020, but that is no longer true.

It is not that stocks and bonds are always negatively correlated.

In his bestselling book, Stocks for the Long Run, Prof Jeremy Siegel noted that since the Asian financial crisis in 1997/98, US government bonds are viewed as a hedge against market turmoil. To wit: “Prior to the Asian crisis, stock and bond prices often moved in the same direction because inflation was the primary worry for investors. Subsequently, concern shifted to deflation and possible global crises, and US government bonds became a safe haven. The correlation between stock and bond prices turned negative.”

Indeed, a high and rising inflationary environment is awfully bad for equities and bonds. With inflation now a key concern, stock and bond prices are now positively correlated again. A positive correlation means that the two asset classes often move in the same direction. A negative correlation means they move in opposite directions.

We do not know if the currently high inflation is transitory. What if inflation becomes the primary worry for investors again?

I present here the real annualised returns for some major asset classes during the 1970s, a decade with high inflation: US large cap (-5.3%), EAFE stocks (-1.6%), US 10-year bond (-4.2%), foreign 10-year bond (0.8%), commodities (9.7%) and gold (25.5%). The annualised return for the US 60/40 portfolio was -4.6% for the decade.

If we have a fund that generates subpar returns for a long period, there will be calls for the fund’s restructuring or management team revamp or both. The fund unit holders are likely to exit in droves too.

The future is inherently unknowable. Investors could face deflation, disinflation or high inflation some time down the road. Generally, stocks thrive in disinflation, bonds in deflation and gold in a stagflation-type economic environment. The purpose of asset allocation should be building a well-diversified portfolio to produce stable and decent returns in varied economic environments.

It is my humble opinion that a well-diversified portfolio needs to include not only stocks and bonds, but more importantly real assets such as commodities and gold.

In his book, When Markets Collide, which was published in 2008, Mohamed El-Erian, who used to manage the Harvard University endowment fund and is now an adviser to investment management firm PIMCO, has this to say on asset allocation, “It is not just that the average investor does not allocate enough to international equities in a broad diversified portfolio; he or she is probably also underexposed to ‘real assets’ — that is, instruments that tend to preserve their value during periods of higher inflation.”

A glance at the asset allocation of our local government-linked investment companies reveals that their portfolios are mostly stock- and bond-centric. Perhaps it is now time to rethink their asset allocation strategies in their portfolios?

Ching Poy Seng is a private investor. He was previously a researcher at an international consultancy and Asia-Pacific director at multinational companies.

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