By John L. Bowman, CFA, Executive Vice President for the CAIA Association.
Economic super cycles are far from a new topic. Perhaps the most famous examples are the technically inspired Elliott wave and the technologically grounded Kondratiev wave, named after Soviet economist Nikolai Kondratiev, who was executed for his evangelism of the topic. Despite the general dismissal of long-wave theory by economists and the academy, no one can deny that when the history gods periodically align geopolitical tailwinds and technological breakthroughs, extended periods of economic vitality, wealth creation, and capital market returns can occur. Han Dynasty paper, the British navy, the steam engine, electrification, and more recently the internet are arguably just a few examples.
These transitions should not be likened to market timing opportunities that demand asset allocation tweaks, but rather tectonic shifts of the global economic crust that alter history and reset normalcy. At CAIA Association, we believe we are in the twilight of a four-decade economic super wave. But the next phase will neither be constrained by sovereign borders nor necessarily inspired by one killer app. This new era will have more far-reaching implications, particularly for the asset management profession.
Since their peak in 1981, developed market interest rates have precipitously declined due to unprecedented accommodative monetary policy by the central banks across the G7. Ten-year yields in the U.K. and U.S. averaged ~12% in the 1980s and ~6% in the 1990s. German and Japanese yield cycles were not as pronounced but followed the same pattern. As the global financial crisis (GFC) paralyzed global credit markets and burst the real estate bubble a dozen years ago, the expansionary intervention only accelerated with asset purchases and liquidity injections, sending rates down to near zero and even below in parts of Europe. The “Greenspan put” symbolized a lengthy period of desperation by global policymakers to prop up financial assets and provide near limitless and free access to credit.
This long period of cheap capital and easy money has catalyzed innovation, created countless jobs, and provided a relentless tailwind for capital market returns. In fact, a plain vanilla U.S.-based 60/40 portfolio has compounded at more than 10% since 1980, and the return has been even more attractive in the last decade. CAIA Association data suggests that global investable assets reached $153 trillion at the end of 2020, with 12%, or $18 trillion allocated to alternatives. Meeting an 8% actuarial return at a pension, a 7% retirement return expectation for a family, or a 5% real spending rate at an endowment has not been a challenging hurdle. But professionals must ask whether this environment is truly normal or has been an extended holiday that is due to finally sunset.
As we enter 2022, yields are flat to negative around the globe, inflation seems to be awakening from its 40-year hibernation, and global strategists expect the 60/40 portfolio to return a meager 3-4% in the next 10 years. How will tomorrow’s investment professional meet the demands of their clients under these conditions?
CAIA Association believes the Portfolio for the Future™ will exhibit five distinct marks, and we’ve enlisted friends and respected thought leaders to help us explore their implications:
1. Broadly Diversified
Commonfund CEO and CIO Mark Anson, CAIA, argues that responsible portfolio management consists of collating a series of uncorrelated beta and risk premia that offers a combination of income, inflation protection, capital preservation, and principal growth to meet a required return. During recent years the unlikely narrative has been heralded that financial assets, particularly public equities, eternally march upward. The proliferation of new, low-cost products has created complacency and “beta creep.” As such, fiduciaries must be more creative in expanding their investment opportunity set. That begins with a return of the foundational principle of diversification across asset classes, geography, sector, and purpose.
2. Less Liquid
The traditional 60/40 public equities and fixed income allocation has provided extraordinarily well in the last decade. But Andrea Auerbach, Cambridge Associates global head of private investments, counsels us not to take solace in the recent past. Investment professionals will have to look to differentiated sources of return, notably private capital, to increase the potential of being able to fully meet their obligations with responsible control of risk.
Private capital has become increasingly attractive for earlier stage, new economy, and growth companies. And, because private capital is detached from the short-term machinations of public markets, it liberates investors to take advantage of market dislocations, information asymmetry, and out-of-favor or countercyclical opportunities. Avoiding private capital in a portfolio denies access for clients to an increasingly large portion of the global economy. Of course, private markets are far from a silver bullet given their opacity, high fees, need for patience, and wide risk-return dispersion, and therefore must be carefully considered in light of client liquidity, income needs, and risk tolerance. Extensive due diligence and thoughtful, deliberate manager selection is imperative.
3. Rooted in a Fiduciary Mindset
Investment management is an agency business. Asset managers exist to deliver trust, care, and expertise to clients. Roger Urwin, Global Head of Content at the Thinking Ahead Institute, explains how a fiduciary mindset begins with an existential understanding of purpose, alignment, and service to the client. “Systems leaders” are responsible for translating these values into behavioral norms that influence ownership structure, client communication, compensation, fees, talent recruiting, culture, and definition of success (benchmarks). The investment profession—and each client’s Portfolio for the FutureTM—still has work to do on this journey through mitigating conflicts of interest, asymmetric payoffs, incentive dislocations between limited partners (LP) and general partners (GP), and unnecessary financial engineering.
4. Actively Engaged
The age of the universal owner has arrived. Clients are demanding both positive financial and social outcomes from their capital allocation and underlying holdings. No one knows this better than Anne Simpson, Global Head of Sustainability, Franklin Templeton and former Managing Investment Director of Board Governance & Sustainability, CalPERS. With a devastating global pandemic, climate consciousness, and the pursuit of clean energy alternatives at a fever pitch, investment professionals are integrating sustainability elements such as carbon footprint, progress on diversity, equity and inclusion (DEI), human-rights records, and labor practices into their security evaluation, risk management, and return expectations. Further, non-financial disclosures, as well as ESG ratings, are becoming more accepted as a regular, integrated part of security analysis. The Portfolio for the Future™ will be much more insistent and proactive in ensuring that it contributes to a more inclusive and sustainable tomorrow.
5. Dependent on Operational Alpha
The modern investment profession is highly competitive. New sources of comparative advantage are being cultivated among enterprising professionals, writes Ashby Monk, PhD, Executive Director, Stanford Research Initiative on Long Term Investing. Firm culture, governance, and technology are much more predictive of sustained performance than previously thought and should be emerging priorities for any leader. The Portfolio for the FutureTM will be driven by firms that innovate and exploit new organizational and operational models to save cost, reduce risk, and pioneer new investment ideas.
The industry needs to be reoriented back toward a north star of sophisticated portfolio construction, one that prioritizes client and beneficiary outcomes and works tirelessly to achieve those outcomes in a long-term, sustainable way. This essential definition of professionalism will usher in a new identity of enlightened self-interest that culminates in a much-improved public warranty. The Portfolio for the Future™ is CAIA Association’s contribution and call to action for that transformation.
If you enjoyed this article, be sure to read CAIA Association’s new report, The Portfolio of the Future.
About the Author:
John serves as Executive Vice President for the CAIA Association, overseeing the industry leading CAIA charter, thought leadership and content development, and CAIA's Asia Pacific strategy. John has devoted over 20 years to the asset management industry to recover the narrative of the value that the investment profession bring to society. He is a staunch public advocate for market integrity, long-termism, investor outcomes, diversity, human dignity and educational standards, as necessary ingredients to building a sustainable and healthy profession.
John previously served as Managing Director for the Americas for CFA Institute, a region comprised of 40+ countries from Canada, the U.S., Central America, South America and the Caribbean. Bowman joined CFA Institute in 2004 after holding several industry positions. He served as a portfolio manager at Mellon Growth Advisors (MGA), where he was responsible for portfolio construction and stock selection for the MGA International Growth and MGA Global Growth strategies. Bowman also served as a portfolio manager for the International Growth Opportunities Strategy at State Street Global Advisors (SSgA) in its Global Fundamental Strategies Group. John is a prolific writer and commentator, frequently appearing in industry and business publications such as the Wall Street Journal, The New York Times, Pension and Investments, Financial Advisor, The Independent, Wealthmanagement.com and CNBC. Bowman earned a BS in Business Administration from Mary Washington College and is a CFA charterholder.