Do you really want to set and forget?

December 10, 2018

Yesterday's solution

We started Drummond Capital Partners with a view to providing private clients with a better wealth management and investment solution. The annual returns of investment markets are clearly positive over a long period of time, and when markets go through bad periods often the advice is to effectively stand pat. This advice may be appropriate for a young professional with 30 years of earnings and accumulation ahead of them, but for investors who are approaching retirement or have just sold a business and invested their life’s work, this is the last thing they need.

It is difficult for advisors to actively manage for this risk under the operating model adopted by most wealth management businesses today. Advisors providing quality technical advice to their clients often lack the time, resources or experience to implement a dynamic tactical asset allocation strategy. Even if an advisory firm has the internal expertise to manage a dynamic strategy, it requires a lot of client contact and administration to implement effectively across a diverse client base. The cumbersome nature of the operating model and the risks involved in making an error means advisory firms are averse to making changes. This is the reason why advisory firms are inclined to rely on long term return assumptions and stick to a mainly static asset allocation strategy.

Do you really want to set and forget?

While relying on long term average return of assets classes to decipher optimal portfolios is fine, it doesn’t really account for the variation that can occur in the medium term nor the changing relationships between assets over time.  Diversified asset allocation typically refers to having a combination of growth assets (equities) and defensive assets (bonds). Bonds did exceptionally well during the financial crisis in 2008 while equities did poorly. So by owning bonds your overall portfolio performance was better than just owning equities. Yet even this relationship changes dramatically over time (see below).

Rolling 5-year US Bond & Equity Correlation (1926-2018)

Source : Drummond Capital Partners, R. Shiller

Clearly there are times in capital markets when you want exposure to risk premia and times when you don’t. For this reason, active capital management is a core tenet for Drummond Capital Partners. We base our strategic asset allocation on 40 years of data given some 90% of returns are derived from long term asset allocation decisions rather than individual security or manager selection. Yet we know, and expect, that the future will be very different from the past.

Importantly, we recognise that each client’s investment experience can differ wildly depending on when they began their investment journey. A 20% drawdown today can equate to a large dollar value for investors that have already accumulated a large pool of assets that may not be so concerning to those at the start of that journey. Our primary obligation (and our obsession) is to manage this risk for our clients. No one knows the sequence they will get into the future. It is not acceptable to just assume that future returns will resemble the long-term average return without active management.

To help put into perspective the necessity for active asset allocation, consider the forward 10-year total return from the ASX All Ordinaries Accumulation Index.

ASX Forward 10yr Return vs Average Return

Source : Drummond Capital Partners, Reuters

As you can see, the average annual return from 1979 to 2018 has been 11% p.a. However, someone beginning their investment journey in 2007 on the premise of the long term 11% return but then only achieving 3% pa over the next 10 years, may indeed wish they had opted for a different asset mix given the coming volatility in equities. The severely negative returns through the financial crisis in 2008 get completely swallowed by average returns over long periods. While this supports the argument to stick with it in fear of making the wrong decision at the wrong time, it doesn’t make the person in question feel any better about their actual experience.

Of course, we cannot predict the future of markets any better than the next person and we don’t try to. We do however know that recommending to our clients a static asset mix based on long term average returns simply doesn’t reflect what their actual experience will be like. Instead of being put in a static box of defensive, balanced or growth for example, most clients we speak to want to take risk when it’s going up, and take chips off the table when it’s not. It’s common sense.

Fundamentally we believe in winning by not losing.

Realistically, severe negative periods are typically felt in equity markets every decade. So not being able to significantly reduce risk when fundamental market conditions change just doesn’t make sense. The problem is that there is no single set of rules that works, no single event or indicator that works across time in all markets. And of course, markets often go down faster than the time afforded to investors on the way up. That’s why investors must be nimble and have conviction.

Using a set of fact-based inputs along with significant experience as active portfolio managers to drive the tactical asset allocation framework over the medium term (i.e. moving the portfolio between a growth and balanced or conservative position) a dramatically better outcome can be achieved. By adopting this approach, we do miss some of the peaks but our clients avoid the worst of the significant market drawdowns. Over time this preservation of capital and active participation in the good times creates a significantly better investment journey.

Ultimately we believe a considered, experienced and rational approach is required with a capital preservation mindset always at the fore.


Prepared by Drummond Capital Partners (Drummond) ABN 15 622 660 182, AFSL 534213. It is exclusively for use for Drummond clients and should not be relied on for any other person. Any advice or information contained in this report is limited to General Advice for Wholesale clients only.

The information, opinions, estimates and forecasts contained are current at the time of this document and are subject to change without prior notification. This information is not considered a recommendation to purchase, sell or hold any financial product. The information in this document does not take account of your objectives, financial situation or needs. Before acting on this information recipients should consider whether it is appropriate to their situation. We recommend obtaining personal financial, legal and taxation advice before making any financial investment decision. To the extent permitted by law, Drummond does not accept responsibility for errors or misstatements of any nature, irrespective of how these may arise, nor will it be liable for any loss or damage suffered as a result of any reliance on the information included in this document. Past performance is not a reliable indicator of future performance.

This report is based on information obtained from sources believed to be reliable, we do not make any representation or warranty that it is accurate, complete or up to date.  Any opinions contained herein are reasonably held at the time of completion and are subject to change without notice.

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