StashAway’s Asset Allocation Framework

01 Mar 2017

Executive Summary

  • StashAway brings to every investor an institutional-level, sophisticated investing framework that centers around asset allocation. Our investment framework focuses on achieving the highest returns at all risk levels by building any given portfolio with passive exposure to asset classes through low-cost, highly liquid, very diversified ETFs. This strategic approach eliminates the enormous consumption of resources typically associated with securities selection. This paper serves to detail how we implement this strategy, and the economic considerations we take when making investment decisions.
  • Drawing on solid foundational research in both academia and the practitioners’ world, we deploy a strategy that we call 'ERAA,' or Economic Regime-based Asset Allocation, that provides the means to make portfolio decisions intelligently and cost-efficiently. By incorporating the inherent impacts of different economic forces into every investment decision, this approach addresses what Modern Portfolio Theory (MPT) fails to consider: external economic forces ultimately drive asset class returns and correlations.
  • The framework takes into consideration economic factors and their momentum to assess the macro environment; it uses mid-term valuation gaps and their mean-reversion to embed a forward-looking view on asset class performance; and it looks at market expectations on Fed Funds rate and market dynamics for risk management purposes.
  • Risk management is at the very heart of ERAA, which is intrinsically designed to navigate the ups and downs of economic cycles. After in-depth backtesting, we confirmed that ERAA would have outperformed in risk-adjusted terms during the global financial crisis of 2008.
  • As of writing, we currently observe inflation momentum outpacing growth. If this situation persists, investors’ portfolio holdings need to be adjusted to this new situation. Cash is not a solution. Precious metals, inflation-linked bonds, and technology stocks will be key building blocks of any portfolio. Our intuitive platform and advanced technology and investment strategy will intelligently adjust any portfolio under our management to acknowledge and address changing economic situations.

Asset Allocation over Securities Selection

According to the mid-2016 SPIVA US Scorecard, 94.58% of US domestic equity fund managers who participate in active fund management have underperformed the relevant passive index benchmark in the past 5 years. In other words, only about 5% of active fund managers delivered positive returns against their benchmark. Data for other countries and time periods are comparable. Further, several long-term studies have concluded that asset allocation is responsible for between 80% and 96% of a portfolio’s return profile.

At StashAway, we do not engage in securities selection, and we refrain from using actively managed funds; instead, we build our customers’ portfolios with a carefully selected assortment of highly diversified, liquid and low-cost exchange-traded funds (ETFs). These index-tracking investment tools enable our customers to gain diversified, long-term exposure to a variety of asset classes and geographies. In other words, rather than deciding whether to buy more shares of General Motors or General Electric, we determine how much we should allocate towards North American Large Cap Equities versus Emerging Market Equities or Gold, for example.

Traditionally, portfolios have been optimised according to the Nobel Prize-winning Modern Portfolio Theory (MPT). However, academic and industry research indicate that MPT fails to consider the impact of external, changing economic conditions and how they impact returns. Our strategy, ERAA (Economic Regime-based Asset Allocation) addresses this shortcoming by incorporating the impacts of economic regimes into every investment decision. With this approach, we create holistic, efficient portfolios that harness the persistence of economic regimes.

Economic Regimes: What are they, and how many are there?

StashAway defines an economic regime as a function of the rates of changes in both growth and inflation. We have identified four distinct economic regimes – (i) contraction, (ii) disinflationary growth, (iii) inflationary growth, and (iv) “stagflation.” As will be discussed in a later section, the returns and risk profile of each asset class could vary significantly across these economic regimes, therefore impacting the preferred asset allocation of any given portfolio.

Figure 1 – Four Distinct Economic Regimes


Contraction (Regime A) – The bottom-left quadrant in Figure 1 represents a contractionary phase in economic activity. This cycle tends to be accompanied by falling wages, which in turn compromise consumers’ abilities to spend. To the extent that the general prices of goods and services are falling, we have a recession with deflationary price pressure. The Global Financial Crisis of 2008, when the US led the global economy into a recession, is an exemplary episode of Regime A.

Disinflationary Growth (Regime B) – When the economy comes out of a recession, and growth momentum is sustainably larger than its inflation equivalent, real growth starts to increase. This is an ideal economic environment in which the quality of growth is high. Having bottomed out in the middle of 2009, the global economy started to recover and went into Regime B for a 36-month period, between March 2012 and February 2015. At the time of writing, the US is leading again the global economy into the lower boundary of Regime B.

Inflationary Growth (Regime C) – As the economy continues to “heat up” and inflation rises beyond a certain threshold (3.1% for the US and 2.3% for Asia ex-Japan), the quality of growth starts to deteriorate. In other words, “real” growth declines. In Regime C, each additional unit of output is increasingly produced at higher costs. In this environment, investment returns from risky assets are also likely to be falling. Since 2000, the world has witnessed a few short-lived episodes in Regime C (e.g., the US economy from October 2007 through March 2008, and from May 2011 through November 2011). In coming years, central banks will continue removing stimulus for the first time since 2008 to reverse ultra-low interest rate policies. Accordingly, StashAway anticipates longer lasting occurrences of Regime C for the first time in decades. We have learned from the lessons in the 1980s and early 1990s that the erosion of asset returns from higher inflation could be detrimental to an unprepared portfolio, including a portfolio with too much cash.

“Stagflation” (Regime D) – When inflation is left unchecked and spirals out of control, costs of production for companies and disposable income of consumers could be eroded by price pressures. In other words, inflation “eats” into growth under Regime D, and the economy goes into a rare and horrible combination of “stagnation” and inflation. Although there were several short-lived “stagflations” in modern times, classic examples are the global economy before and after the oil embargo of 1973.


How Economic Regimes Impact Asset Allocation

As previously mentioned, the returns and volatilities of assets behave differently in different economic environments. The ability to identify economic regimes and adopt differentiated asset allocations in different regimes helps to enhance a portfolio’s long-term risk-adjusted return.

In general, equities are expected to perform well when growth is positive and running with greater momentum than inflation. However, not all stocks are made equal. In “good” times, small-cap growth stocks will outperform stocks in defensive sectors, such as consumer staples. Conversely, when the economy contracts, defensive stocks will likely fare better than growth stocks with lower-realised volatilities.

Figure 2 has four graphs, each depicting returns in a particular economic regime, based on ERAA. Each “dot” in the figure represents the historical average return and volatility of a given ETF. Each ETF represents a unique asset class. For instance, SPY is an ETF that tracks the S&P 500 index, GLD tracks Gold, and XLP replicates the Consumer Staple sector. The “dots plot” in orange color represents the possible number of optimal portfolios with varying levels of target volatility that can be constructed from these ETFs. The optimal portfolio composition varies depending on the economic environment, but generally is composed of 8 to 12 ETFs that provide exposure to 6,500 to 14,500 underlying securities.

What are the key insights from Figure 2? A misleading way of looking at, say, the SPY, which tracks the S&P 500 index, is to look only at its long-term average historical return of 9.8%. Since 1982, the US economy has spent 10.5% of its time in Regime A, in which the S&P 500 returned an average return of negative 10.3% YoY. It spent 48.7% of its time in Regime B, with +16.4% returns YoY; 29.8% of its time in Regime C, with +8.8% YoY; and 10% of time in Regime D, with +2.7% returns YoY. Other asset classes changes go in different directions: for instance, mid-duration US Treasury Bonds (TLH) show higher average returns in Regime A than in Regime B.

This fluctuation in returns and time spent in different economic regimes clearly illustrates that returns of an asset class can vary a lot in different regimes. The same happens to volatility and correlation of other asset classes.

Simply looking at long-term averages is not an option if you are looking to increase returns in all economic environments, which is why StashAway harnesses these medium-term economic cycles to improve returns over risk for our customers.

Additionally, for each asset class, StashAway assesses mid-term valuation gaps and their mean-reversion to embed a forward-looking view on asset class performance.


Figure 2 – Asset Class Returns & Optimal Portfolios Vary Across Economic Regimes



Macro Risk Management

By design, ERAA is intrinsically designed to navigate the ups and downs of economic cycles. Hence, macro risk management is at the very heart of our investment logic. Moreover, StashAway looks at market expectations on Fed Funds rate and looks at market dynamics to identify times where macro data do not represent market expectations; when this happens, StashAway applies an “All-Weather” strategy to all of its portfolios until signals become clearer.

This dual approach would have worked very well in past financial crises. This can be illustrated by reviewing how the approach would have performed in the global financial crisis of 2008.

As depicted by Figure 3a, the US economy was moving from Regime B (“disinflationary growth”) to Regime C (“inflationary growth”) toward the later part of 2007. This period was characterized by positive growth with an inflation rate that was higher than 3.1%. The first warning sign of growth came in May 2008 when US industrial production registered its first negative print of -1.0% YoY. As it turned out, growth momentum had turned negative while headline inflation was around 4.1% and rising. By the time Lehman Brothers failed in September 2008, US industrial production had deteriorated from -1% to a low of -8.3% YoY. This represented a shift from Regime C (“inflationary growth) to Regime D (“stagflation”).


Figure 3a – Risk Scenarios: The Global Financial Crisis of 2008

Post Lehman bankruptcy, headline inflation managed to stay around 5% for some time. It was not until December 2008 that the first negative inflation momentum was observed. Thereafter, inflation started to dip rapidly. By July 2009, the US economy had shifted from “stagflation” to a regime that was simultaneously in deflation and a recession (Regime A).

In brief, ERAA would have spotted the first signs of trouble and started reducing portfolio risks in May 2008. By December 2008, when negative inflation momentum was observed, the investment algorithm would have made another shift, from a “stagflation” posture to a recessionary portfolio.

The benefits of this approach can be observed in Figure 3b. The ERAA portfolio would have significantly outperformed both the S&P 500 as well as the 60-40 stock-bond benchmark throughout the crisis. It also would have had significantly fewer drawdowns.


Figure 3b – Risk Scenarios: The Global Financial Crisis of 2008


Note: Past performance is not an indicator of future outcomes; investing exposes you to risk of loss due to random unforeseen events or changes in the economic cycle.


Long-term Results

Throughout the last 15 years, ERAA would have performed very well. To illustrate, depending on risk levels chosen, an investment of $100 SGD made in August 2002 into “regime-optimised” portfolios would have grown to between $271.52 SGD (“balanced”) and $303.90 SGD (“very aggressive”). Both portfolios would have outperformed the $258.81 SGD terminal NAV realised by the S&P 500 index. When compared against the HFRI macro hedge fund and HFRI fund of fund composite indices, the outperformance of regime-optimised portfolios is even greater. These proxy indices for actively managed funds have only grown an investment of $100 SGD made in August 2002 to between $166.29 SGD and $199.92 SGD.


Figure 4 – Regime-optimised versus Passive and Active Portfolios


Note: Past performance is not an indicator of future outcomes; investing exposes you to risk of loss due to random unforeseen events or changes in the economic cycle.


Current Situation and Looking Ahead

Current data show that the US has just led the global economy into the lower boundary of “Regime B” (positive growth with controlled inflation), with rising inflation momentum. While we are not in the business of forecasting, our data-driven analytics are flagging inflation momentum, far outpacing growth. As a result, there is a high probability of a risk scenario that the US and global economies could head into either Regime C (inflationary growth) or Regime D (stagflation) in the coming future. These economic regimes present significant downside risk to portfolios, as the rising cost of production tends to erode nominal growth, and require a tailored asset allocation strategy; even more importantly, high inflation erodes the purchasing power of cash and makes a portfolio with too much cash inefficient. Given accelerating inflation momentum, precious metals, inflation-linked bonds, and technology stocks will be the key building blocks of any portfolio going forward.

Thus, ERAA offers tremendous value to investors. ERAA will provide us with the framework necessary to apply the key attributes of various economic cycles; and technology has provided us the means to create and deliver these highly-sophisticated portfolios at scale, at low cost, to anybody, with no minimum investment requirement.

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