Paper Suggests Asset Allocation Adjusted to Inflation and Growth

October 27, 2011 ( - Investors who dynamically adjust asset class exposures as growth and inflation expectations shift may significantly improve risk-adjusted returns, according to a white paper from BNY Mellon Asset Management’s Investment Strategy and Solutions Group (ISSG).
A back-tested portfolio based on ISSG’s methodology that adjusted allocations according to changes in growth and inflation expectations over the last 23 years achieved nearly a doubling of the risk-to-return Sharpe ratio (a higher Sharpe ratio implies a higher return for the same amount of risk), when compared with a typical institutional portfolio, according to the report, Great Expectations: Regime-Based Asset Allocation Seeks Higher Return, Lower Drawdowns, This approach to asset allocation also may provide meaningful downside protection in periods of market stress, such as the bursting of the technology bubble in the early 2000s and the global financial crisis of 2007-2009, the report said.

The ISSG report concluded that growth and inflation expectations in the U.S. over the last 40 years included a more complex pattern of macroeconomic regimes and transitions than many investors assume. Changes in growth and inflation expectations rather than simply changes in growth or inflation significantly can affect asset class performance, according to the report.

The group used these insights to develop a model to predict the probability of regime changes and adjust portfolio exposures accordingly. “We think asset allocation approaches that are mindful of, and responsive to, portfolio risk factors across regimes have the potential to achieve investors’ long-term return objectives, while better protecting against devastating drawdowns,” said Jeff Saef, Managing Director of BNY Mellon Asset Management and head of ISSG, in a press release. “Given the challenging investment environment, we believe investors should consider a more opportunistic approach to asset allocation strategies.”