CIO Insights: How we put your money to work – the nuts and bolts of ERAA™, our investment framework

Our Economic Regime Asset Allocation (ERAA™) framework is the foundation for how we safeguard and grow the wealth that our clients have entrusted to us. Using our proprietary models combined with the Nobel Prize-winning optimisation methodology, it positions your portfolios in a way that aims to keep your selected risk level constant while maximising for long-term returns – all throughout changes in the macroeconomic environment.

Since ERAA™ has signalled a shift in this environment – which triggered a reoptimisation in our portfolios – we wanted to take this opportunity to provide a refresher on our framework, along with the enhancements we’ve made to it over the past few years.

In this month’s CIO Insights, we take a look under the hood of ERAA™, and how it guides us in making the best investment decisions for you.

Key takeaways:

• Diversification is the only free lunch: Data show that it’s asset allocation, not security selection, that drives over 90% of long-term portfolio returns. It’s why we built our ERAA™ framework on the tenets of Modern Portfolio Theory (MPT), which uses diversification to achieve higher returns for a given level of risk.

• ERAA™ adapts to the macro cycle: On top of ensuring that our portfolios tap into the power of diversification, our systems use real-time economic data to pinpoint where we are in the economic cycle. Using that information, our portfolios can be positioned to navigate changing economic and market conditions. This is further supplemented by rigorous risk-management and governance measures.

• ERAA™ has shown proven performance: ERAA™'s allocations have helped our General Investing portfolios post solid returns and beat their same-risk benchmarks over the past two years. That came despite being in a challenging macroeconomic environment of stagflation – or one of low growth and high inflation.

• The cycle is shifting, and ERAA™ is responding: The latest readings from ERAA™ point to a change in the economic regime to one of high inflation and improving growth. Given this shift, we see opportunities in equities, longer-duration bonds, and higher-risk assets in general – ERAA™ has reoptimised your portfolios accordingly.

Asset allocation – not security selection – drives the majority of portfolio returns

The portfolios managed by our ERAA™ framework have been the core of StashAway’s offering since 2017. ERAA™ was built upon the foundation of decades of academic research. Its systematic approach avoids human biases, and enables the use of thousands of historical data points in each portfolio construction decision.

Why is this important? Research has consistently shown that actively-managed funds – which aim to outperform the market over a short time horizon – tend to underperform their benchmark indices over both the near and long-term.

The 2023 SPIVA US Scorecard, which compares the performance of active US fund managers against their relevant S&P benchmarks, found that: 

• 75.3% of domestic US equity funds underperformed the S&P Composite 1500 index in 2023, and
• 94% of these funds underperformed the S&P Composite 1500 index over the past 20 years.

In addition, seminal academic studies like Determinants of Portfolio Performance have found that asset allocation is responsible for upwards of 90% of a portfolio’s returns over time.

The fundamental reason behind this is that securities (like a single stock or a bond) within an asset class tend to be highly correlated. For example, when the Covid pandemic rattled markets in March 2020, it didn’t matter whether you picked Microsoft or Apple – both stocks sold off. 

On the other hand, there can be a significant difference in performance across asset classes. Again, using Covid as an example, while equities went down, bonds went up as investors fled to safe-haven assets.

The takeaway here: diversification might be the only ‘free lunch’ in investing. Simply put, when you put together asset classes that tend to go up over the longer-term, but are not correlated in the shorter-term, you can achieve higher returns for the same level of risk.

ERAA™ adds a layer of intelligence on top of portfolio diversification

Asset allocation is the guiding principle behind Modern Portfolio Theory (or MPT – see the Glossary at the end for more), the Nobel Prize-winning methodology deployed by many asset managers to construct Strategic Asset Allocation (SAA) portfolios. These types of portfolios are commonly set up with a longer-term focus based on a customer’s risk profile and investment preferences, and don’t change with macroeconomic and market conditions.

However, one drawback of using this static approach is that the risk of the portfolio may change over different macro environments. For example, a very aggressive investor with a 100% equity allocation may experience heightened volatility during recessionary periods, compared with high-growth periods.

This is where ERAA™ comes in. It enhances SAA portfolios by repositioning them according to changes in the economic “regime” (more on that below). This is done to target a constant level of risk no matter where we are in the economic cycle. For example, in an expanding economy, portfolios can take on more equity risk; in a contracting one, portfolios can be protected by higher allocations to safe-haven assets, such as cash and gold.

In late 2022, for example, ERAA™ signalled a shift to stagflation and adjusted asset allocations accordingly, adding the necessary protection for such an economic regime.

How ERAA™ defines economic regimes

ERAA™ uses real-time data to monitor the macro environment and pinpoint where we are in the economic cycle. Based on that, it divides the cycle into 4 regimes along the axes of growth and inflation:

• Good times: As the name suggests, this is a great environment for risky assets as growth is positive while inflation remains low. Stocks perform the best under this regime.

• Inflationary growth: As the economy heats up, inflation picks up as well. This is typically when commodity prices start to surge, and cyclical assets perform well.

• Stagflation: As central banks tighten policy to fight inflation and slow the economy, stocks see greater volatility, while protective assets like cash equivalents and gold tend to perform well.

• Recession: Both growth and inflation turn negative. In this regime, bonds can provide protection to a portfolio, as central banks start to loosen monetary policy to stimulate growth.

Over the past few years, we’ve also enhanced ERAA™ to allow it to give us a more granular read into the economic cycle. Each regime has been further divided into two “states” according to whether or not growth is accelerating or decelerating. This helps us to fine-tune our portfolios’ asset allocations if needed, with the ultimate goal of improving your investment returns.

Managing risk is the core of ERAA™

Any system can go haywire if the appropriate controls aren’t put in place. That’s why we’ve built rigorous risk-management and governance measures into our investment processes.

From the very start of portfolio construction, ERAA™ uses a metric that we call the StashAway Risk Index (SRI) to establish the level of market risk for each portfolio. In more technical terms, we employ the 99th percentile Value-at-Risk (VaR) over a 12-month period (our Glossary below also covers this). This is then used to determine your portfolio’s asset allocation. 

On top of that, to further aid in managing risk in your portfolios, we’ve improved our portfolio construction techniques by incorporating:

• Constraints on tracking error: This ensures that any deviations from a portfolio’s same-risk benchmark would be within a limit that’s set in accordance to that portfolio’s volatility.

• Maximum allocations to single sectors or countries: This ensures that ERAA™ does not overexpose portfolios to any single, narrow asset class.

Finally, StashAway’s advisors, investment committee, and investment team bring their decades of investment and market experience to provide oversight on ERAA™’s outputs – ensuring a holistic risk management process is in place.

Improving ERAA™’s benchmarks to reflect structural market shifts

A portfolio’s benchmark helps investors understand the basis of its construction and its expected behaviour. For example, a fund that allocates to broad US equities would likely have the S&P 500 as its benchmark. 

As ERAA™ invests in globally-diversified asset classes, it also uses them to form its benchmarks – each of which has the same level of market risk (measured by VaR) as its corresponding portfolio. While the benchmarks are static, ERAA™ aims to outperform them by adjusting your portfolios’ allocations as the economic regime changes. 

With that in mind, structural shifts in markets – which have taken place in the years since our benchmarks were first established – mean they need to be updated. These changes will better reflect ERAA™’s investing universe, as well as help us better manage risk going forward. The two main enhancements we’ve made are:

• Adding ultra-short-dated US Treasuries to our lower-risk benchmarks, or those for SRI 14% and below. Given that the bond market has seen a structural increase in volatility and a higher interest rate environment in recent years, this helps to produce portfolios that have lower risk without sacrificing returns. 
• Including gold in all General Investing portfolio benchmarks as a defensive, diversifying asset versus equities and bonds, to produce better risk-adjusted returns throughout economic cycles.
  

ERAA™ is built with best-in-class ETFs 

A problem that many investors face is how to select a fund that best represents a given asset class. At StashAway, we use a systematic framework to assess the available funds that represent each asset class. by screening for and scoring each ETF along 6 key criteria:

• Sufficient liquidity, taking into account a fund’s total assets and trading volumes, and the liquidity of the underlying securities.

• Cost effectiveness, factoring in management fees, bid/ask spreads, and taxes.

• Effectiveness of the benchmark, and a low tracking error versus the benchmark.

• Credibility and reputation of the ETF issuer.

• Simplicity of the ETF, meaning no added features like leverage or derivatives.

• Track record of at least 3 years for the ETF or its underlying index.

Combining the factors above results in a quantitative scoring, which helps us to identify the best ETFs to include in our investing universe.

ERAA™’s asset allocations have helped your portfolios navigate the high inflation environment in recent years

To demonstrate the power of ERAA™, let’s take a closer look at how our medium-risk SRI 22% portfolio – our equivalent of a balanced 60/40 stock-bond portfolio – has performed during the past two years of elevated inflation and volatile markets.

As shown in the chart below, ERAA™’s allocations have allowed our SRI 22% portfolio to post lower drawdowns, less volatility, and higher returns compared to its same-risk benchmark – with a gain of +0.2% since the start of 2022 versus a loss of -4.8% for a static 60/40 allocation.

This was due to ERAA™’s allocations to energy-related equities and gold as inflation peaked in 2021 and 2022, followed by a more defensive tilt to shorter-duration bonds and large-cap equities amid the stagflationary environment that emerged in late 2022.

Similarly, looking at SRI 6.5, our lowest risk portfolio with a focus on fixed income, ERAA™’s defensive positioning and overweight position on short-duration helped to minimise losses to -4.8% over the past two or so years of heightened bond volatility. That compares to a whopping -16.7% for its same-risk benchmark.

Here’s more on our ERAA™-managed portfolios’ latest performance.

ERAA™ is signalling a shift back to inflationary growth

ERAA™ has signalled that the macroeconomic environment is shifting once again. Based on the latest data, the economic cycle has transitioned from the Stagflation regime back to Inflationary Growth, which also triggered a reoptimisation of our portfolios.

As the new regime signals that growth is returning, ERAA™ is allocating more to asset classes that can benefit from an environment of economic expansion. This means a greater emphasis on equities, and increased allocations to higher-yielding bonds. 

We want to help you build and protect your wealth for the long-term. It’s why our team of experts have worked hard to continuously upgrade the nuts and bolts of your ERAA™ portfolios since they were launched in 2017 – and why you should expect to see further enhancements in the months and years ahead.

Our investment framework will continue to manage your portfolios in a way that both keeps your risk level constant and adapts to prevailing economic conditions. That way, you can rest assured that your money is always working for you.

Glossary of Terms

Modern Portfolio Theory (MPT)

An approach to portfolio construction that aims to maximise returns within a level of risk. Diversification is a key component, and the theory focuses on the correlations between different asset classes.

Value-at-Risk (VaR)

This metric estimates maximum potential losses over a period, at a certain confidence level. A one-year 99% VaR of 20% means a 99% chance that an investment won’t lose more than 20% of its value in any given 12-month period.

Strategic asset allocation (SAA)

A systematic, longer-term investment approach that establishes target allocations for different asset classes and adjusts them periodically to maintain desired risk-return characteristics.

Tactical asset allocation (TAA)

A more active approach to investment management encompassing a range of strategies. A TAA portfolio manager shifts asset allocations according to the opportunities and risks in the market.

Disclaimers:

Our same-risk benchmarks are proxied by MSCI All Country World Equity Index TRI for equities (prior to 1 March 2023 are proxied by MSCI World Equity Index TRI) and FTSE World Government Bond TRI for bonds. The benchmarks we use have the same 10-years realised volatility as our portfolios.

Model portfolio returns are expressed in gross terms before fees, withholding taxes, and reclaims on dividends. They are provided only as a gauge of pure performance before other items.

Actual account returns may deviate from the model portfolios due to differences in the timing of trade execution (e.g. during the day vs close), timing differences and intraday volatility of reoptimisation and re-balancing, fees, dividend taxes and reclaims, etc. All returns are in USD terms.

Past performance is not a guarantee for future returns. Before investing, investors should carefully consider investment objectives, risks, charges and expenses, and if need be, seek independent professional advice.

This communication is not and does not constitute or form part of any offer, recommendation, invitation or solicitation to purchase any financial product or subscribe or enter any transaction.