Asset Allocation Research for UK advisers

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• The US economy outperformed expectations
• The long-awaited pivot came through
• Portfolio resilience proved key

As we look forward to 2025, it is worth revisiting the themes and predictions of our 2024 outlook “turning the corner” to get a sense of what we anticipated at the time, how this informed our recommendations to UK adviser firms’ investment committees.  Asset class performance for 2024 is summarised in the chart above.  Our 2025 outlook is published separately.
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Steady as she slows
In 2024, we anticipated a gradual deceleration in the U.S. economy, with markets pricing in the likelihood of a slight recession. In the event, the U.S. economy surprised on the upside. Growth forecasts were upgraded from 1.15% at the start of the year to an impressive 2.6% by year-end. This revision supported robust equity market returns and served as a reminder of the resilience of U.S. economic fundamentals.  In summary, a resilient US economy defied expectations.
What did we recommend to our clients at the outset and during the year? We took a balanced view between accepting concentration risk (traditional S&P 500) and diversified (active, sector exposures).  We also recommended clients lean in to broader US equity corporate landscape via 1) Equal Weight and 2) US Small Caps exposures.
By contrast, the UK had that shrinking feeling as regards economic growth, and although out of a technical recession, we are not confident of its prospects relative to the US.

Pause before pivot
At the close of 2023, we were focused on the Federal Reserve’s pause in interest rate hikes, noting that a rate cut was a question of when, not if. While the consensus view was that the first cut would be announced by mid-2024, we anticipated that the timing would hinge on the performance and strength of the U.S. economy. Indeed, the economy’s resilience delayed the start of what we anticipate to be a rate-cutting cycle to September 2024, when the Federal Reserve finally delivered a significant 50-basis-point cut.
In fact, the eventual BoE Fed pivot came a month or two later than we had estimated at the start of the year, but we recommended our clients remain dynamic with regards to duration management.  We recommended clients go strongly overweight duration in June as a good time to extend duration ahead of BoE cuts, with Fed following suit, and we saw the additional duration deliver returns on the bond side of the portfolio before attention shifted to debt supply and the UK budget later in the year, which led us to recommending to move back to neutral.

The importance of portfolio resilience
Our focus on resilience proved vital when it came to navigating the key macro factors in 2024: Growth, Inflation and Interest Rates.
For Growth, anticipating a soft landing for the US economy, we highlighted the potential outperformance of cyclical sectors, and momentum, yield and size factors. In the event, momentum emerged as the best-performing factor, with yield and size also delivering strong returns. For Rates, we adjusted duration exposure mid-year to capture the effect of falling policy rates, aligning portfolios with a changing interest rate environment. For Inflation, which remained above target, the inclusion of liquid real assets (but to a lesser extent than in 2022) and shorter duration inflation-linked bonds, ensured continued portfolio resilience.  We continue to emphasise the importance of a diversified alternatives exposure from a correlation perspective, not just in name.
Our recommendation to consider Private Market Managers and Gold & Precious Metals paid off during the year – as these were the best performing asset classes for the year, outperforming world and US equities.

Political and Geopolitical risks
In a year of elections, we saw a change in government in the UK and in the US following Trump’s Presidential win.  Both have a greater impact on bond yields and currency dynamics than equity markets, in our view.
Geopolitical risks remain elevated with the Russia-Ukraine war continuing to grind, escalating conflict and contagion in the Middle East – all at tragic human cost.

Conclusion
Markets did indeed turn a corner in 2024, with economic growth, earnings and equity market returns outperforming expectations.  With 2024 in the rear-view mirror, it’s time to look ahead to 2025.  Our 2025 outlook is published separately.

Henry Cobbe, CFA
Head of Research, Elston Consulting

Elston's ESG Specialist, Andrea Acimovic, outlines how new disclosure rules around ESG funds will impact decision-makers.
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• Yield is back
• Selectivity matters more
• Inflation’s getting stickier

2022 proved to be a challenging year with pressure on equities and bonds a like in face of rising rates and soaring inflation.  In our 2023 Outlook: Looking for Light, we explore three key themes
1. Yield is back: for equities, bonds and alternatives - the yield drought is over
2. Selectivity matters more: within and across asset classes
3. Inflation is getting stickier: getting past the peak, but still a problem

Read the summary article

Find out more:

• The full version of our 2023 Outlook report is available to our clients.  For UK advisers requesting further information, please contact us.
• Watch the recent 2023 Outlook webinar discussion with Henry Cobbe, Hoshang Daroga (Elston) and Natasha Sarkaria, CAIA (BlackRock)

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• The European coal market has been tight
• Extending or restarting coal-fired plants is quickest fix to supply
• Coal consumption is at record high in 2022

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• Focus on ESG risk will become a requirement
• Screening approaches can be simple or nuanced
• Choice of index methodology is key

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Elston's ESG spcialist, Andrea Acimovic, outlines the evolution of ESG investing.
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• Adapting portfolios for inflation
• Income generation in a negative real yield world
• Positioning portfolios for climate transition

 
2021 in review
Our 2021 market roundup summarises another strong year for markets in almost all asset classes except for Bonds which remain under pressure as interest rates are expected to rise and inflation ticks up.
Listed private equity (shares in private equity managers) performed best at +43.08%yy in GBP terms.  US was the best performing region at +30.06%.
Real asset exposures, such as Water, Commodities and Timber continued to rally in face of rising inflation risk, returning +32.81%, +28.22% and +17.66% respectively.

2022 outlook
We are continuing in this “curiouser, through-the-looking glass” world.  Traditionally you bought bonds for income, and equity for risk.  Now it’s the other way round.
Only equities provide income yields that have the potential to keep ahead of inflation.  Bonds carry increasing risk of loss in real terms as inflation and interest rates rise.
Real yields, which are bond yields less the inflation rate, are negative making traditional Bonds which aren’t linked to inflation highly unattractive.  Bonds that are linked to inflation are highly sensitive to rising interest rates (called duration risk), so are not attractive either.
How to navigate markets in this context?
The big three themes for the year ahead are, in our view:

1. Adapting portfolios for inflation
2. Income generation in a negative real yield world
3. Positioning portfolios for climate transition

We explore each in turn, as well as reviewing updated Capital Market Assumptions for expected returns from different asset classes.

See full report in pdf
Attend our 2022 Outlook webinar

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• Transitioning to a low-carbon economy is critical
• ‘Green-washing’ is a problem
• Selection methodology is key

 
“A code red for humanity. The alarm bells are deafening and the evidence is irrefutable.”
UN Secretary General Antonio Guterres discussing the most recent Inter-Governmental Panel on Climate Change (IPCC) report published in August 2021.

For advisers looking to incorporate a Net Zero approach into a client portfolio, where ESG preferences are high, we would advocate a three-step approach.

1.Understand the Carbon footprint of your existing portfolio
2.Consider how substitutions of traditional with ESG-screened funds could reduce that Carbon footprint
3.Consider whether, and to what extent, an allocation towards climate solutions, which by their nature may be higher risk investments, will actively contribute to achieving the path to net zero.

A bias towards ESG and a moderate investment in climate solutions, can help achieve those objectives for those clients who seek climate-oriented values in their investment portfolio, as well as their day-to-day living,

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• In June 2018 we launched a Zero Carbon Portfolio for a university endowment fund
• The objective was to deliver the performance of a global equity index whilst fully excluding companies with exposure to fossil fuels and positively including Socially Responsible Investments
• In addition to a successful back-test, the live portfolio has delivered on objectives

What is Zero Carbon investing
The Zero Carbon Society at Cambridge University is one of many campaign groups calling for university endowment funds to divest from all fossil fuels.  This has been termed “Zero Carbon” investing.
The divestment trend started in the US in 2012 when the city of Seattle divested from fossil fuels.  In 2014, Stanford University followed suit.  Campaigns across the US and UK led to other universities following suit.  Some of the reasons universities found it hard to ensure that their investments were “fossil free” is because:

• Collectives: Use of collective investment schemes meant it was hard to pressure fund houses to change investment style, on something that would affect all clients
• Alternatives: Use of hedge funds and alternative strategies meant it was hard to vouch for full exclusion on a look-through basis
• Trackers: Use of low-cost tracker funds meant indirect exposure to energy stocks
• Definitional uncertainty: if you invest in a FTSE 100 future does that create “exposure”?
• Opportunity Set: Concern about a narrowing of the investment opportunity set
• Methodology: low carbon and ESG funds could nonetheless include energy companies with strong green credentials and substantial investment in renewable energy

The challenge
When set this challenge by a university college, we proposed to do two things.  Firstly to create a Zero Carbon SRI benchmark to show how Zero Carbon investing could be done whilst also focusing on other ESG considerations.  Secondly, to create a Zero Carbon portfolio to deliver on the primary aim of full divestment.
 
Creating a Zero Carbon SRI benchmark
We wanted to create a benchmark for the endowment’s managers that not only screened out fossil fuels, but went further to screen out one of the main consumer of fossil fuels, the Utilities sector, as well as other extractive industries – namely the Materials sector.  We also wanted to screen in companies with high ESG scores and low controversy risk and cover the global equity opportunity set.  We worked with MSCI to create a custom index, the catchily-named (for taxonomy reasons) the MSCI ACWI ex Energy ex Materials ex Utilities SRI Index (the “Custom Index”, please refer to Notice below).

Creating a Zero Carbon portfolio
The second part of the project was to create an implementable investment strategy that maintained a similar risk-return profile to World Equities, but fully excluded the Energy, Materials and Utilities sectors.  Rather than creating a fund which introduces additional layer of costs, this was achievable using sector-based ETF portfolio.

This portfolio meets the primary objective of creating a Zero Carbon, fully divested, world equity mandate.  In the absence of ESG/SRI sector-based ETFs, it is not yet possible to create a sector-adjusted ESG/SRI ETF portfolio.  But we expact that to change in the future.

Custom Index Performance
The back-test of both the custom index could deliver similar risk-return characteristics to global equities.  The concern was would those back-test results continue once the index and portfolio went live.  The answer is yes.  Whilst the custom index has shown outperformance, that was not the objective.  The objective was to access the same opportunity set, but with the fossil-free, ESG and socially responsible screens in place.

Fig.1. Custom Index performance simulation from June 2012 & live performance from June 2018

Zero Carbon Portfolio performance
Similarly, the Zero Carbon portfolio has delivered comparable performance to MSCI World – hence no “missing out” on the opportunity set whilst being fully divested from fossil fuels.  Although not intentional, the exclusion of Energy, Materials & Utilities has benefitted performance and meant that the performance, net of trading and ongoing ETF costs, is ahead of the MSCI World Index.

Fig.2. Zero Carbon ETF portfolio performance from June 2018

Summary
Whatever your views on the pros and cons of divestment, Zero Carbon investing is not an insurmountable challenge, and the combination of index solutions and ETF portfolios solutions creates a range of implementable options for asset owners and asset managers alike.

IMPORTANT NOTICE ABOUT THE CUSTOM INDEX
With reference to the MSCI ACWI ex Energy ex Materials ex Utilities SRI Index (“Custom Index”). Where Source: MSCI is noted, the following notice applies.
Source: MSCI.  The MSCI data is comprised of a custom index calculated by MSCI, and as requested by, Queens’ College Cambridge.  The MSCI data is for internal use only and may not be redistributed or used in connection with creating or offering any securities, financial products or indices.  Neither MSCI nor any third party involved in or relating to compiling, computing or creating the MSCI data (the “MSCI Parties”) makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and the MSCI Parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to such data.  Without limiting any of the foregoing, in no event shall any of the MSCI Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.

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Sign up for our upcoming webinar on incorporating ESG into model portfolios

Summary

• Indices codify a criteria-based approach to ESG investing
• Index methodology means screen, score and weight each company
• ESG indices enable similar performance, but with ESG compliance

 
Defining terms
With a growing range of ethical investment propositions available to portfolio designers, we first of all need to define and disambiguate some terms.

• Ethical investing: this is an established investment approach that considers investors’ social and moral preferences, and typically relied on exclusions (typically excluding companies with exposure to “vice” – for example armaments, gambling or alcohol).  Traditionally the approach of religious charities, this approach is becoming mainstream.
• Environmental, Social and Governance (“ESG”): the index provider, MSCI, rates companies based on their approach to Environmental issues (such as Climate change, Natural resources, Pollution & waste and Environmental opportunities); Social issues (such as approach to Human capital, Product liability, Stakeholder opposition and Social opportunities); and Governance issues (such as Corporate governance and Corporate behaviour)[1].
• Socially Responsible Investing (“SRI”): using MSCI’s definitions, this approach incorporates ESG ratings as for ESG, but goes one step further to exclude companies whose products have negative social or environmental impacts; removing companies involved in Thermal Coal mining and power generation; and exclude companies involved in controversies.

​Criteria-based approach works well for indices
Applying ESG criteria to a universe of equities acts as a filter to ensure that only investors are only exposed to companies that are compatible with an ESG investment approach.
Creating a criteria-based approach requires a combination of screening, scoring and weighting.
Looking at the MSCI World SRI 5% Capped Index, for example, means:

1. Screening: removing companies with exposure to Nuclear Power, Tobacco, Alcohol, Gambling, Military Weapons, Civilian Firearms, GMOs, Thermal Coal and Adult Entertainment.
2. Scoring: means only including companies that score above a certain level on their MSCI ESG Rating and MSCI Controversies score.
3. Weighting: to make sure the final index has similar risk-return exposure to the parent index (so as not to impact portfolio construction parameters such as risk, return and correlation); index methodology can target similar sector and region weights as the parent index.  Furthermore to ensure that, as a result of all this screening and scoring and weighting adjustments, single-stock exposure (which creates systematic risk) does not become too concentrated, a 5% cap restricts the allocation to any single stock.

 
Indices codify criteria
An index is “just” a weighting scheme based on a set of criteria.  A common, simple index is to include, for example, the 100 largest companies for a particular stock market.  SRI indices reflect weighting schemes, albeit more complex, but importantly, represent a systematic (rules-based) and hence objective approach.  However, the appropriateness of those indices is as only as good as their methodology and the quality of the screening, scoring and weighting criteria applied.

Proof of the pudding
To mix metaphors, the proof of the pudding is in the making of performance that is consistent with the parent index, whilst reflecting all the relevant scoring and screening criteria.  This allows investors to have their ESG cake, as well as eating its risk-return characteristics.
Contrast, for example, the MSCI World Index with the MSCI World Socially Responsible Investment 5% Issuer Capped Index.  The application of the screening and scoring reduces the number of companies included in the index from 1,601 to 386.  But the weightings adjustments are such that the relative risk-return characteristics are similar: the SRI version of the parent index has a Beta of 0.98 to the parent index and is 99.4% correlated with the parent index.
 
Fig.1. Comparative long-term performance

Source: Bloomberg data,
​Focus on compliance, not hope of outperformance
Indeed pressure on the oil price and the performance of technology this year (technology firms typically have strong ESG policies) means that SRI indices have slightly outperformed parent indices.
However, our view is that ESG investing should not be backing a belief that performance should or will be better than a mainstream index.  In our view, ESG investing should aim to deliver similar risk-return characteristics to the mainstream index for a given exposure but with the peace of mind that the appropriate screening and scoring has been systematically and regularly applied.

​[1] For more on this ratings methodology, see https://www.msci.com/esg-ratings