This article was contributed to us by the StashAway team.
StashAway is a digital wealth manager that empowers people to build their wealth in the long-term, through an easy-to-use and transparent platform that gives cost-efficient access to sophisticated investing. This article focuses on the third part of StashAway’s value proposition, its sophisticated investment framework, while does not touch its simplicity and cost-effectiveness.
How Does StashAway Invest?
Investing is a 2-step process. First, an investor needs to decide how much to invest in an asset class (e.g., 5% or 20% in North American Equities? 0% or 10% in Gold?) and, secondly, needs to select the specific securities to invest in (e.g., of the 20% asset allocation to North American Equities, how much should be invested in Amazon shares? How much Apple? And General Motors?).
The first step is known as “asset allocation”, the second as “securities selection”. Asset allocation is demonstrated to account for 80% of variations in returns between portfolios.
StashAway focuses on asset allocation and does not spend time and money on securities selection, by simply investing in the entire market through ETFs or Index Funds (e.g., S&P500 for “Large Cap US Equities”); this strategy is commonly referred to as “passive investment”.
How Does StashAway Focus On Asset Allocation?
Traditionally, portfolios are managed based on the Modern Portfolio Theory (MPT) or its variation. In essence, they are usually based on a framework for thinking about risk and returns. In the case of the Nobel-winning MPT, it postulates that an efficient portfolio is one that invests in multiple asset classes. For the same risk, the efficient portfolio would have better long-term average return than a concentrated investment.
StashAway builds upon the efficient portfolio foundation and goes further to include economic regimes data in its portfolio construction considerations. Our investment framework, ERAA®, stands for Economic Regime-based Asset Allocation. ERAA® has the key objective of helping investors navigate the ups and downs of the economy by harnessing a large number of persistent and high-quality signals from economic data. In essence, ERAA® makes informed data-backed decisions on how to allocate assets.
The Origin Of ERAA®
ERAA® is a result of a multi-year journey of discovery by the StashAway team. This journey involves data-driven research, collaboration and the assimilation of best practices from both academia and the practitioners’ world.
For the last couple of decades, some of the most sophisticated institutional investors have used macro-focused systematic frameworks to craft asset allocation strategies. The power of such frameworks became obvious during the Global Financial Crisis in 2008, when an economic regime change of unprecedented scale triggered a very severe bear market.
No prior experience in the market or amount of news flow would have armed the trader or fund manager for such a financial tsunami. To those that lived those days, a clear need arose for an investment framework that would adapt in these unexpected conditions and provide the higher risk-adjusted returns that investors seek.
ERAA® is a result of these experiences. It’s a systematic investment framework that embeds persistent and high-quality signals from the economy in its analyses to optimise medium-term asset allocation, and incorporates asset classes’ valuations information and market trends to manage risk and optimise returns. ERAA® takes a risk-centric approach, that focuses on managing each client portfolio’s risk over medium and long-term cycles.
ERAA is built on 3 pillars: economic regimes, respecting valuations and managing risk.
What Are Economic Regimes? Why Are They Important?
ERAA® builds upon MPT’s principles of maximising risk-adjusted returns to account for external factors affecting a portfolio, such as those in our economic environment. This is important because some of these external changes can persist for 3 to 7 years or more.
Shown in Figure 1 is a simplification of ERAA® ‘s first pillar which identifies four distinct economic regimes based on the relationship between growth and inflation: (i) recession, (ii) disinflationary growth, (iii) inflationary growth, and (iv) stagflation.
Recession (Negative Growth And Low Inflation)
The bottom-left quadrant in Figure 1 represents a contractionary phase in the economy. This cycle tends to be accompanied by falling wages, which in turn compromise consumers’ ability to spend.
Disinflationary Growth (Positive Growth And Low Inflation)
This is known as the “good times” when growth tends to outpace inflation. In other words, inflation-adjusted growth is positive which is particularly conducive for growth-oriented assets such as stocks to outperform.
Inflationary Growth (Positive Growth And High Inflation)
As the economy continues to heat up and inflation rises beyond a certain threshold, the quality of growth starts to deteriorate. In other words, “real” (inflation-adjusted) growth declines. In this regime, each additional unit of output is increasingly produced at higher costs which reduces profit margins. For consumers, their real purchasing power is also diluted.
Stagflation (Negative Growth And High Inflation)
When inflation spirals out of control, the costs of production for companies rise and profit margin suffers. For consumers, their disposable income is eroded by inflation. In other words, inflation “eats” into growth so severely that the economy goes into a rare and horrible combination of recession and high inflation. This is known as stagflation. There were several short-lived stagflations in modern times, and classic examples are the global economy before and after the oil embargo of 1973.
As the economy moves from one regime to another, the returns and risk of an asset class would correspondingly change with it. Figure 2 illustrates the average returns, between January 1982 and December 2017, of the S&P 500 across the different economic regimes. In a recession, the S&P 500 averaged a yearly return of -10.4% but it can return +16.4% in good times. If good growth is accompanied by high inflation, profit erosion can see average returns be diluted to a high single digit return (8.8%). When we have stagflation, the S&P 500 can return an average of +2.7% with very high volatility.
Figure 3 illustrates how differently asset classes can perform across economic regimes. As you can see, US Government Bonds tend to perform significantly better than the S&P500 in times of recession, and worse than the S&P500 in good times. When the economy changes, each asset class’ expected returns and volatility change, and so does its correlation with all other asset classes.
ERAA® takes note of these facts and adjusts each portfolio’s asset allocation to the medium-term economic cycle to leverage on each asset’s behavior in the different economic regimes, with the goals of managing risk and maximising returns.
How ERAA® Respects Valuation
When the economy is doing well and inflation is low, the stock market tends to outperform. As mentioned in the S&P500 example in Figure 2, the asset class averages a return of 16.4% per annum in such an economic situation. However, if, for example, the stock market is already over-valued by 6.4% per annum relative to economic factors, then its expected return could not be 16.4%, it has to be lowered to 10.0% as the market has “priced-in” part of the expected returns!
More importantly, significant overvaluation can reflect larger issues such as concentration risk in the market from FOMO (fear of missing out). Conversely, when the market is significantly undervalued relative to fundamentals, it could be a reflection of rampant pessimism driven by FOF (fight or flight) in the market. This scenario presents the patient investor with opportunities to build diversified portfolios at great reward to risk ratios!
How Does ERAA® Manage Uncertainty?
At the systemic level, ERAA® monitors leading economic indicators and the relationship between asset prices versus economic data for any signs of trouble. In addition, ERAA® also monitors information or patterns embedded within specific asset classes for further signs of risk.
When uncertainty is high, ERAA® activates the “risk shield” and adopts an “all-weather” strategy stance or even temporarily allocates funds dedicated to specific assets to protective assets.
Join The Future Of Investing
In short, ERAA® operates on its core pillars to construct portfolios for our clients that are resilient across economic cycles and hence maximises returns for every dollar of risk taken over the medium and long-term. You can read the full white paper which dives deeper into the economic regimes and each pillar here or attend our Academy seminar, A Deep Dive into StashAway’s Asset Allocation Investment Framework conducted by our Chief Investment Officer, Freddy Lim.
At StashAway, investors gain access to institutional-level investing at incredibly low cost. Our fee structure is simple and transparent and range from 0.2% to 0.8% p.a. depending on the value of your assets under management. There is no minimum balance required and you have full control over your deposits and withdrawals at no additional charge. If you’d like to try a sophisticated investment product at a low cost, you can do so by signing up with this link.
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