Traditional asset allocation may not suit the new world of higher interest rates and higher inflation and a more dynamic approach to portfolio construction will be required to generate attractive returns as stock markets come under pressure, according to Schroders Australia.

The ability to move between different asset classes will be a key to boosting portfolio performance and helping provide downside protection, as returns from share markets fall from their highs of recent years, according toSimon Doyle, CEO and CIO for Schroders in Australia.

“We think inflation will be generally higher and more difficult to keep close to 2 per cent. Share markets are likely to be more volatile than investors have been used to over the past few years as the world changes,” MrDoyle said.

He predicts the returns from Australian shares over the next three years will sit just below 7 per cent a year, compared to a historical average of 8 to10 per cent.

“Australia is looking better than the United States (US), which still looks quite challenged from a valuation perspective. There is potential for more downside in the US in the short term. We are positive structurally on commodities, which could be a source of upside return for Australia’s sharemarket, which is one of our preferred share markets.”

According to Doyle, the world has been living in an age of abundance but, due to several converging forces, has moved into an age of scarcity, with no more cheap labour or cheap energy and with higher interest rates increasing the cost of capital.

“We believe this will lead to greater cyclical and market volatility,  which has significant implications for investment markets and more importantly, the investment framework investors use to build portfolios,” said Doyle.

“Active management and asset allocation will become more important than it has been in the past.”

“In the current environment, asset breadth is good, backed up by active management, to allow investors to navigate a more challenging path forward -but also a rewarding one if investors get it right.”

Sebastian Mullins, head of multi-asset in Australia, says higher inflation and higher rates will affect asset allocation directly.

“These conditions of higher inflation and interest rates will demand more active tactical asset allocation in portfolio construction. As the cost of capital rises, company earnings will be under greater pressure.”

“We have adopted a value bias, and favour companies which we consider to have cheaper multiples and quality, inflation linked earnings. Those with extreme valuations will likely come under pressure,” said Mr Mullins.

“When it comes to duration, being more active in terms of which country, duration selection and currency selection will matter.”

Mr Mullins said investors will also need to adopt a more flexible approach to portfolio construction.

“The way investors implement a 60:40 portfolio is important – and that comes down to the risk tolerance of an investor and their adviser. From our perspective, it is about being more dynamic and knowing when to add more or less to a portfolio There are some great opportunities in both the 60 and the40 for active investors.”

“If you are in a 60:40 regime, what you put in the 40 per cent will depend on the economic environment. But the yield being offered on that 40 percent is a lot higher than it has been in the past, and if you are a retiree, you want to access that yield. There are good opportunities to increase the yield aspect of your portfolio in this higher inflation environment,” MrMullins said.

The Schroder Real Return Fund is a multi-asset fund providing diversified exposure across defensive, growth and alternative assets. This actively managed fund aims to achieve a return of CPI* plus 4 per cent to 5 percent a year before fees over rolling 3-year periods while minimising the size and frequency of negative returns.

By diversifying across a wide range of asset classes, sectors and regions and actively managing the asset allocation, the fund seeks to achieve long-term growth and manage downside risks as markets rise and fall.

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