Issue: December 2012 / February 2013
Expert Opinion

Asset class modelling key to inflation-beating returns

When deciding on how to structure an investment portfolio, asset class characteristics and savings objectives need to be considered. A clearly defined methodology aimed at identifying and motivating the use of selected asset classes is therefore necessary, believes Momentum Manager of Managers head of research, Eugene Botha.

Botha . . . specific objectives
need to be considered

Asset allocation frameworks designed to meet savings goals in terms of inflationary targets over specific investment periods necessitate that asset classes adhere to certain predetermined characteristics. These include being unambiguous (exhibiting a single clearly-defined meaning), measurable (returns being easy to calculate), investable (material amounts can be easily allocated and removed), appropriate (being suitable for retirement and retail investment), liquid (easily invested or disinvested) and diversified (add value to a portfolio).

Considering the asset-class combination that best adheres to these principles, and is most likely to achieve inflation- beating returns over the savings timeframe, becomes the next step. The asset blend selected is then implemented using growth, inflation-linked bond and absolute-return strategy components, with diversification being key to the entire process.

Each allocation mix is designed with a view to maximise the probability of achieving inflation-beating returns, minimising drawdown (the term to describe the peak-to-trough cycle in investment returns) and better managing shorter-term capital loss risks over the specified investment period. Asset class modelling is undertaken on the basis of expected real returns in an effort to avoid extreme outliers (dangerous and uncommon events) skewing the analysis and results therefore being biased toward better-performing, and perhaps unsuitable, investments.

The probability of asset-class combinations delivering on various inflationary targets over the longer term (10 years) is indicated in the table:

  CPI+7% CPI+6% CPI+5% CPI+4% CPI+3%
Local equities 59.87% 66.37% 72.65% 80.04% 88.12%
Local bonds 28.48% 32.96% 38.57% 43.27% 45.07%
Local property 45.29% 51.57% 54.48% 60.54% 68.16%
Local cash 4.71% 21.97% 27.58% 32.29% 41.03%
Local commodities 40.58% 44.84% 50.45% 54.04% 56.50%
Global equities 41.93% 45.96% 55.38% 61.43% 64.13%
Global bonds 44.62% 51.35% 58.97% 63.00% 66.37%

When combining asset classes in accordance with the savings term and objective (and in line with Regulation 28 global and total equity constraints), a portfolio structured, for example, over a sevenyear rolling period and with a cpi+7% goal, is made up of the following asset-class combination:

Portfolio CPI +7%
(return potential percentage)
Local equities 50%
Local bonds 2.5%
Local property 10%
Local cash 7.5%
Local inflation-linked bonds 5%
Commodities -
Global equities 20%
Global bonds 5%

Risk management is another important consideration as inadequate planning for potential capital-loss exposures could significantly erode returns. Although, for example, equities offer the highest probability of delivering on all inflation targets over the longer term, there is risk attached.

Gauging risk can be undertaken using various means. They include assessing drawdown relative to the inflation target. This gives an indication of potential underperformance relative to the investment aim.

Designing portfolios with specific investment objectives provides the investor with the best chance of achieving growth and delivering on these pre-specified objectives over time. Developing strategic asset-allocation frameworks is therefore essential. It should include a complementary investment management approach and manager selection process.