How to set asset allocation in an uncertain world

Many advisers note that asset allocation is one of the most important decisions they and their clients make. So, what are advisers suggesting now?

Equities have the highest potential return, but also the highest risk. Fixed income such as government bonds have the lowest risk but usually provide the lowest return. Every investment comes with its own risks and market fluctuations.

Questions often asked are, is there an expectation that the global economy and its constituent individual country markets will continue to grow? Or, by contrast, do professional investors anticipate a recession? For the latter, would it be global, Western countries only, or maybe just in the US, or possibly even China?

If growth is expected, many advisers suggest overweighting equities. If a recession is on the cards, most tend to suggest being overweight to fixed income.

Beyond the basics

But it doesn’t have to be that simplistic. For example, investors can dig further into the detail and allocate their assets to high and low-risk stocks, or to short and long-term bonds. 

A range of stocks will grow in value even if there is a recession. Similarly, some fixed income will perform better in a recession. For example, there will always be demand for one sector or another, such as food and drink; and ingredients to make batteries for increasingly popular electric vehicles. 

Accordingly, the answer to the asset allocation challenge is determining the sectors and companies which will perform in a range of economic situations.  These can then form the core of an asset allocation. For instance, an investor could hold a portion of their investment in shares, some in private equity, and allocate a portion to private credit or lending if it is available. 

Once the core allocations have been determined, satellite investments can be added to boost income, such as buying dividend-paying stocks or fixed income assets that provide a reliable return. 

For some investors, this approach will also form their core investments. 

More risk-tolerant investors, or younger investors with a longer-time frame, might like satellite sector investments such as technology or artificial intelligence-related stocks or even renewables related investments like lithium stocks that have greater upside potential, but also greater risks. For example, new technologies are constantly emerging and more efficient electric batteries may be developed that do not require lithium.

Another choice is to use options to protect the listed aspects of a portfolio. Hedging can allow an investor to limit downside risk while waiting for the market to turn. 

Options can also be used as another way to potentially generate income, notes the AUSIEX options trading team.

Institutional investor insights

International shares are the largest single asset allocation for many of the country’s institutional investors.  For example, AustralianSuper in its balanced portfolio, global equites account for 28.5% and similarly with the Future Fund having an allocation of 22.9%. 

AustralianSuper – balanced option

Global equities 26.1%
Australian equities 20.9
Fixed interest 18.7
Private equity 5.4
Unlisted infrastructure 15.2
Listed infrastructure 0.3
Unlisted property 4.8
Listed property 0.5
Credit 3.5
Cash 4.0
Other 0.4

As at 30 June 2023

Future Fund

Global equities 22.9%
Australian equities 8.8
Fixed income / debt securities 8.2
Private Equity 16.4
Property 6.5
Infrastructure & timberland 9.4
Alternatives 17.1
Cash 10.6

As at 30 June 2023

Aware Super – balanced option

Global equities 33.7%
Australian equities 21.6
Fixed & credit income 15.4
Private Equity 5.8
Property 6.5
Infrastructure & real assets 11.7
Alternatives 17.1
Liquid alternatives 0.9
Cash 4.4

As at 31 July 2023

As seen, global equities are often the major single asset allocation for the big institutional investors. In the case of the Future Fund, it allocated 17% to developed markets and 5.9% to emerging market equities.  This is followed by Australian equities. 

The allocations then diverge, with the Future Fund having more in longer-term alternatives and private equity given its much longer-term investment horizon.

Allocations will vary depending on an investors’ objective, how long they will be invested and how much they are seeking in terms of returns. There are a range of ways to invest to meet those goals with no one specific allocation. Accordingly, offering options and suggesting a range can be more effective in terms of an asset allocation conversation.