Karen Watkin: Welcome to AB's Alpha Females, the Multi Asset Investment podcast from AllianceBernstein. I'm Karen Watkin and I'm a fund manager in the Multi Asset Solutions team here at AB. The Alpha Females are those women who have developed unique areas of expertise and made their mark in the investment industry. For many clients, generating income from their investments is a priority. But market conditions are very different now from those that we've had over the past decade. So, taking a flexibility approach to income and getting original and informed perspectives to investing is more important than ever. In this series, my guests, the Alpha Females share their expert insights on the key questions for investors on the hunt for income. They'll also be telling me about their career journeys, the challenges they faced and the lessons they've learned along the way. What is the value of acting slow in a fast-changing world? That's the challenge and the opportunity when building a long-term asset allocation for investors. Taking a robust investment approach that divides portfolios across different asset classes like stocks, bonds and real estate is critical to generating long-term returns to help clients achieve their financial goals. But conditions around those asset classes can change rapidly, particularly in our currently uncertain world. Change too quickly and too often, then portfolio performance can be fragile. But by contrast, refusing to see or accept changes to underlying assumptions and market conditions may lead to lower long-term returns for investors. So how do you build adaptability and robustness? In short, how can you understand and deal with uncertainty when taking the long-term view? My guest on today's episode is exactly that type of person. Alla Harmsworth is co-head of our Institutional Investment Solutions team, and she focuses on building strategic views based on the bigger economic picture and the state of the capital markets. Alla provides practical insights that can ultimately help investors generate better long-term returns. Alla, welcome back to the podcast.
Alla Harmsworth: Thank you so much for having me again. It's great to be here.
Karen Watkin: So, Alla, you were one of my first guests on the last podcast series and we've got you back again to talk some more about your research. Last time we spoke about one of the big trends impacting asset management at the moment and this rise of passive investing where clients are looking for just low-cost ways of accessing broad market exposures. And you took us through the benefits of active management and actually being able to pick the stocks and bonds that clients need to invest in to generate better investment performance and how to find those active managers. Today I want to take a step back because while clients might be able to access some specific strategies in a passive way, it's very hard to do Your actual asset allocation passively. So that starting point for an investor of what is the right mix of stocks and bonds for them is very individual to what their financial goals are. And that has to be an active decision that they're making. What are some of the things that you think are important to consider when building that starting point, that long term asset allocation for a client?
Alla Harmsworth: Sure. First of all, you're absolutely right that there's no such thing as a passive asset allocation. It is necessarily an active decision, even if you have the passive building blocks and you invest in passive equities and bonds. And getting that mix for the long term is a crucially important decision because research shows very compellingly that over 90% of your return and risk as an investor is going to be determined by that long term core allocation, that long term asset mix, whether it's equities, bonds or regions and sectors within the asset classes. So it's a crucial decision. It needs to be done actively and thoughtfully. And gosh, there's many, many key important things that need to be considered. And as I said, it's a complicated task. Time horizon is crucially important. We need to define exactly what we mean by the long term. Typically, investors think of five to 10 years of strategic asset allocation, but in many cases, we need to think beyond that. We need to be very clear about the client's objectives and constraints. We want to reflect their investment philosophy and beliefs. And crucially important is not just having a view on the paths of the asset returns from here. So, an intelligently formed set of forecasts as a starting point, but also the way that you construct your portfolio, the way that you put those asset return streams together. So, there's many, many, many crucially important steps. It's a process that is reasonably complex, but also very, very value additive, if you get it right. Forming our assumptions and portfolio construction, simply put, other two absolutely crucial aspects of the process.
Karen Watkin: So, you mentioned it, having that long horizon, you know, maybe kind of 10 years, maybe even longer. How do you think about forecasting asset returns so far into the future?
Alla Harmsworth: It's incredibly hard. So, the one thing we need to be humble about is the fact that even the best forecasters can get it wrong. It's just impossible to see into the future. We can have a good go. So, we in AB have a suite of forecasting models called the Capital Market Engine, which allows us to model many, many different assets, the return paths for those assets over multiple horizons and very, very importantly, not just one sort of central expectation, but a wide range of scenarios that each asset path can take. That's a great systematic starting point for us forming our expectations. And on top of that we do a lot of fundamental and more qualitative research to overlay those quantitatively driven forecasts with more fundamental considerations. Sort of things that may be going on in the world that may not be so easy to capture quantitatively.
Karen Watkin: So how, how do you think about assessing which of those dynamics in the market and the economy at the moment are likely to be more tactical in nature and which are likely to have longer lasting effects? Because if we think about building, you know, a long-term asset allocation for clients, how do you think about, you know, how frequently that might change or evolve through time? You know, I think we've been through a period, you know, over the last few years where actually we've seen some fairly kind of big regime shifts in fairly kind of quick succession. So how do you look to, to kind of pick through that in terms of what's going to be a longer lasting change? That should really inform, as you said, the strategic asset allocation that will best serve clients.
Alla Harmsworth: Sure. Well, we have our models as a starting point, as I said, and some of the changes in the environment that we see occurring today, for example, any big shifts in yields or equity multiples can and do affect the strategic outlook for an asset longer term. With other things that are harder to capture quantitatively, we rely on the research, the knowledge and experience and we tend to know what kind of signals or variables have an impact over different horizons. For example, we can observe huge shifts in sentiment to investor positioning, such as what we saw on Liberation Day on the 2nd of April. And we knew that some of that is likely to be just short-term investor sentiment swings, investors perhaps looking for to raise some cash liquidity during considerations. Those sorts of things which are sentiment based, crowding based, positioning based, tend to be very short lived. And while it can be very value additive to make tactical decisions around those swings, that's not what we do from a strategic perspective. On the other hand, different policy announcements that herald an acceleration of de-globalisation as a strategic theme, which we've already been positioning for, that clearly has potential to have more strategic implications.
Karen Watkin: And you spoke at the beginning, you know, it's not just about those forecasts that you build for the different asset classes, but it's also that portfolio construction piece that's really important. So tell me a little bit about how you think about that and how do you look to build an optimal or a robust portfolio and what's the difference in that.
Alla Harmsworth: Actually, that's a great, great question. We have strong views on how portfolio should be constructed. Again, based on lots of research, we believe there's no such thing really as one optimal portfolio. In a sense it might sound worrying, but what I mean by that is that for any given investor, the idea of an optimal portfolio based on one central expectation or one view of the world, even if it's the one that the investor is most certain about, is dangerous. It can basically lead to bad estimation error and to an allocation that just doesn't work because your view of the world does not come to pass, something different happens. As we mentioned earlier, even the best forecasters are prone to error. It's just not possible to have perfect foresight. So, what we look to do in AB is create portfolios that are optimal, but optimal in many different possible scenarios that can unfold. And then we aggregate those possible different optimal portfolios into one portfolio that we call our robust portfolio. It is robust in a sense that it is not as sensitive to one point of view being correct.
Karen Watkin: So, Alla, maybe you've talked a bit about what some of those examples might look like and today in particular we seem to be living in a very uncertain world. Can you perhaps talk a little bit about some of the research you've been doing about why the next decade might look very different to the one we've just lived through and how that's informing perhaps some of your change in perspectives to what makes a robust long-term asset allocation?
Alla Harmsworth: Absolutely. Well, yes, the world is indeed very different now from I think what we've been used to over the past two or three decades. And it's getting even more certain and challenging every day. So, in a sense it's accelerating the changes that we already saw taking place. So, I think it's fair to say over the last sort of three decades or so, an investor would have done very well just investing in an easy default allocation, if you like, to equities and bonds, say with the 60/40 weight. So, as we know, it's been a de facto benchmark. Both assets would have performed well. We had benign growth, we had benign inflation environment, we had a lot of quantitative easing. And that benign macro environment supported both bond and equity valuations. And more than that, it was easier to achieve diversification because bonds tended to be negatively correlated to equities, which is what tends to happen in a reasonably benign environment. So, you could hedge your equity position with having bonds. And it was pretty Much, I mean, speaking simplistically, was a lot simpler to achieve the return objectives that you'd need as, say, a pension plan. What's happening today is, I think, very different. There's a confluence of some structural trends that are occurring at the moment that have been underway for quite some time now, which we've simply never seen before. They are things like deglobalization. They are the demographic changes and the fact that the demographic outlook is looking a lot more complicated and looking a lot worse. For certain, certainly a lot of the developed world, some of the emerging world, and even for the US there is a disruption of artificial intelligence, there's the record levels of government debt, and of course now there's this whole sort of huge geopolitical uncertainty, which in a sense accelerates some of those difficult trends even more. So, it's difficult to untangle the impact of all these things because some of the impact is sort of directionally different from each of these three or four megatrends. But what we're fairly confident about is that it does imply lower growth over the next decade or two. So lower economic growth, it seems to imply higher inflation than what we've been used to and possibly higher for longer levels of interest rates. And that, of course, has impact on what kind of returns we can expect on the key asset classes and, you know, in particular on equities and bonds, which is, you know, which is what gave us easy diversification and strong returns in the past. So, in turn, the high inflation, lower growth, possibly higher rates, do mean, unfortunately, that returns on the major asset classes are going to be lower than what we're used to. And we're looking at, looking at reasonably tougher return outlook. And also, diversification is going to be a lot harder to achieve, we think, than it has been in the past. Simply put, higher levels of inflation, higher uncertainty, higher macro volatility does tend to suggest that the correlations between bond and equities are going to be higher. It might even be positive, as has been the case over the very long history anyway. So that means we need to think very differently about how we construct our portfolios, how we generate return, what diversification means.
Karen Watkin: So, we've talked a lot about how to think about building that long-term asset allocation for clients. And we said at the beginning it has to be an active decision because it ultimately needs to be driven by the financial goals that the investor is looking to achieve. So, for this second series of the podcast, we really want to focus on what it takes when you're investing for Income specifically. So, what are some of the things that would perhaps need to be specific to building a long-term asset allocation if you're focused on generating income for a client as well as long-term returns?
Alla Harmsworth: Sure, that's a great question. And I think many underlying principles for building a truly robust and effective asset allocation are still the same for an income investor as for anyone else. We want that robustness. We want to achieve a steady and smooth return stream. We want to manage our drawdowns and preserve wealth as well achieve growth. Obviously with income we would tilt more towards income generating assets across asset classes. So, we might have a higher allocation to high yield credit, such as high yield or emerging market debt. We may want to add assets such as real estate, which is also potentially good income generator, so there'll be a higher weight that we would hold those assets with within equities. We may also want to tilt towards income generating equities, such as high dividend equities. Put simplistically, those are the types of things we'd look to do. But again, we'd want to combine those income-generating objectives very much with the growth objective because we want to achieve both income and capital appreciation for our clients as much as possible. I think one thing's worth mentioning is there's a special role for factors in an income portfolio which can help us achieve that sort of balance between income and growth and help us protect on the downside, many income generating assets may have something of a value bias which makes them perhaps a bit more vulnerable to cyclical changes in the outlook. So, there would be a case for adding some more defensive factor strategies such as low volatility equities or high-quality stocks to hedge and offset that cyclicality in a portfolio.
Karen Watkin: And so, what would you say are some of the three key insights that your research has given you around what's really important for investors when they're building a strategic or long-term asset allocation?
Alla Harmsworth: I think the key insight and the key sort of principle or aspect of our philosophy is that as we mentioned at the beginning, there is no such thing as passive asset allocation. It is necessarily an active decision and it's also a crucially important one. The impact of your strategic allocation of that long-term anchor to your portfolio swamps everything else over the long term. So, getting that decision right is crucially important and it's just not something that you can sort of do passively or by putting together a few passive indices. The second point I'd mention is again, the crucial importance that we're attached to acknowledging how little we know. No matter how hard work and how much research we do, the world is an uncertain place. And I think that we're seeing that unfold in an incredibly striking fashion today. So, there's no such thing as one optimal portfolio. There's no right set of forecasts, there's no one right allocation. So, we want to protect our clients by building an allocation that is properly robust to many different outcomes. And I suppose another message would be again, the importance of diversification. It's somewhat related to the second point, but also the fact that how we think about diversification needs to be very, very different today. We need to be very open-minded about the types of return streams that we consider for inclusion in our portfolios.
Karen Watkin: Fantastic. And I know you've been, you know, you've been doing this research for a long time now, but within your career, you know, you've moved from actually, you know, kind of generating that research and sharing it with clients on the sell side to coming over to join us on the buy side a few years ago and, you know, working directly with the portfolio managers here. In terms of sharing your research and your insights, can you tell me a bit about, you know, what that transition has been like and the different perspectives sitting on both sides of the fence has given you?
Alla Harmsworth: It's definitely been an amazing learning curve. It's been a hugely satisfying transition and it's also been a challenging one. And I'm still very much learning every single day. The sell side role was great. Our product was research. So, you know, we were generating research. Our research spanned lots of different areas and we spoke to a variety of both asset manager and asset owner clients. But research is what we did. We delivered the research to our clients, we had fascinating discussions, but we didn't always get to see whether our recommendations got implemented. So, I wanted to be closer to the actual investment process. I wanted to see my ideas translated into something that adds value for the portfolio manager and ultimately for our clients. That's what motivated the move, really. And it's been an incredible learning curve. There's a lot of things to do with investability and implementation that you just don't necessarily get to think about when you just do sort of strategy research. There's also something of a publish or perish mentality on the sell side that doesn't necessarily afford you the long time to really think through the implications of your research to really test it again for robustness. All of that I'm learning on the buy side as well as learning about the different objectives and constraints that different investors face, the difference between income investing and other types of portfolios that we have here. So, yeah, it's been a great move and as I said, it's an ongoing learning curve in terms of really taking your insights but making them actionable and making sure that they actually add real value to the client.
Karen Watkin: So, Alla, we've spoken a lot about the importance of having that long term horizon and building that robust asset allocation to see investors kind of through the long term. But we know that it's sometimes incredibly challenging to keep that long-term view when markets are doing all sorts of things in the short term and being able to actually kind of stomach the near-term volatility can be hugely challenging for different investors. How do you try and help them stay the course and keep that long term perspective when markets can feel very tumultuous in the present moment, et cetera?
Alla Harmsworth: He has another great question and another key challenge we experience every day in our job. The way we work with our clients is we're always very keen to be as transparent with them as possible and engage with them on our whole investment process. I was mentioning earlier that we didn't want to create black box forecasting models. We want something that we can explain to our clients. Want something that's robust but intuitive so they understand our strategic asset allocation process, they understand how we form their assumptions, and we try and reflect from the very beginning their investment beliefs and philosophy and how we construct the portfolios for them. So, communicating with the client, keeping them engaged from the start and making sure they understand our decision process and are on board with it is very, very important. And that means that when the time comes, when there's huge volatility or something unexpected happens, we can have a conversation about which part of the portfolio it's affecting. What's a tactical decision? What's a strategic decision? We very much have a tactical process in our portfolios as well, of course. So, it's, you know, we're not downplaying the importance of responding to tactical shifts. So, a lot of the volatility will be responded to in our solutions by the tactical overlays or tactical decisions made by the portfolios. The strategic asset allocation. We will talk to our clients, and we reiterate and communicate the strategic forces that we see at play. We'll comment on the impact of these developments on the strategic outlook for asset classes as they occur and where there is no impact is just as important to tell our clients why we think that the strategic allocation does not need to change at this point. We also reassure our clients that we are on the ball, we're watching the world and where we need to respond tactically, we will. But where we don't need to respond strategically yet, we won't. But we're always monitoring the situation. And our strategic asset allocation is slow moving, but it is responsive. It does very much reflect the market environment. It just tries to do it in a way that only responds to longer term shifts as they occur.
Karen Watkin: And I guess that really comes back to your point, right, about building a robust portfolio so that it's. You've tested those different scenarios out so you're not just building it for one outcome. Actually, you know, it is that kind of all-weather idea that it should be robust to the different scenarios that may play out for clients.
Alla Harmsworth: Absolutely. And risk mitigation and drawdown control is a huge, hugely important part of our process. So, the solutions as a whole should be variable to many ships. And that can also be mitigated further by the tactical overlays that we have. But I think engaging with the client and being in constant communication in response to big events as they occur is an absolute key part of how we keep them focused on the strategic picture and how we help them also differentiate the tactical, more sort of cyclical shifts from the truly strategic trends.
Karen Watkin: One of the things I love about Alla is that she does this deep quantitative work thinking about, you know, how do you build out the forecasts for different asset classes. But then she also recognises that you need some of that intuition. You need to still have a deep understanding of what's driving the world today and what are some of those different forces that will influence what the world and what capital markets are going to be doing, whether that's AI or whether it's changes in DE globalisation. She's thinking about all these issues all the time and is able to ultimately bring them together into thoughtful recommendations for our clients. One of the key things I took away from my conversation with Ala was this idea of building a robust portfolio rather than necessarily an optimal one. So really having that deep research and thoughtful way of building a portfolio that can hopefully weather various different outcomes. We talked about how challenging it is to forecast what asset class or investment returns might look like 10 years into the future. And so that means it's so important to be able to build a portfolio that can deliver on all those different scenarios. You know. We know, particularly today, we live in such an uncertain world that as an investor and when doing this type of research, you really need to think about, you know, what are all the possible outcomes that we might be faced with and how can we build a portfolio that will still deliver for our clients no matter what unfolds? And with that, it brings me to the close of this episode of Alpha Females, the Investment Podcast from Alliance Bernstein with me, Karen Watkin. I hope you've enjoyed this episode and don't forget to tell your colleagues and friends about it. It only remains for me to thank Ala Harmsworth for being my guest today. This episode was produced by Richard Myron from Earshot Strategies.
