StashAway’s ERAA® (Economic Regime-based Asset Allocation)

01 March 2017
Freddy Lim

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At StashAway, we deliver institutional-level asset allocation sophistication to our clients through our proprietary investment strategy, ERAA® (Economic Regime-based Asset Allocation). ERAA® uses macroeconomic data to minimise risk and maximise returns for every portfolio throughout economic cycles.

ERAA® was built with 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. Here’s all you need to know about ERAA® and how it works.

Key takeaways: 

  • Studies have shown that the majority of portfolio returns comes from asset allocation – and it’s the economy, not markets, that drives medium- to- long-term returns.
  • Our investment framework, ERAA®, uses macroeconomic data to minimise risk and maximise returns for its portfolios regardless of the economic cycle.
  • ERAA®’s 4 pillars (regime-based asset allocation, risk control, valuation gaps, and managing asset-specific risk) guide its portfolio construction decisions.
  • ERAA®’s reoptimisation feature protects customers’ capital by maintaining constant risk throughout different economic and market cycles. Reoptimisation can be driven by a change in the economic regime, uncertain economic conditions, or a change in the valuation of one or more asset classes.

How does ERAA® work?

Traditionally, portfolios have been optimised according to the Nobel Prize-winning Modern Portfolio Theory (MPT) – a framework that allows investors to construct a portfolio that maximises expected returns for a given level of risk. However, research indicates that MPT fails to consider the impact that changing economic conditions can have on returns.

Our investment strategy, ERAA®, enhances MPT by addressing external economic forces, which ultimately drive asset class returns, volatility, and correlations.

ERAA® focuses on asset allocation, not stock selection

Research has consistently shown that actively-managed funds tend to underperform their benchmark indices over the short and long term. The 2021 SPIVA US Scorecard, which compares the performance of US active fund managers against their relevant S&P benchmarks, found that:

  • 79.6% of US equity funds underperformed the S&P Composite 1500 index in 2021
  • 90% of these funds underperformed the S&P Composite 1500 index over the past 20 years

Also, several long-term studies have concluded that asset allocation is responsible for between 80% and 96% of a portfolio’s returns.

This is why we focus on asset allocation rather than stock selection. Rather than deciding whether to buy more shares of General Motors or General Electric, we determine how much we should allocate towards North American Large Cap Equities versus Emerging Market Equities, Long Term Government Bonds or Gold, for example.

We build our portfolios with a carefully selected assortment of highly-diversified, liquid, and low-cost exchange-traded funds (ETFs). These index-tracking ETFs provide our customers with diversified, long-term exposure to a variety of asset classes and geographies.

ERAA®’s 4 pillars guide its asset allocation decisions

ERAA® has 4 fundamental pillars that guide its portfolio construction decisions.

Pillar I: Regime-based asset allocation

An asset’s returns and volatility behave differently in different economic environments. In general, equities tend to perform well when growth is positive and running with greater momentum than inflation. But not all equities are made equal.

In good times, small-cap growth equities tend to outperform stocks in defensive sectors, such as utilities or consumer staples. Conversely, when the economy contracts, defensive equities will likely fare better than growth equities. Bonds and Gold also tend to do better than equities when the economy isn’t doing well.

Performance of Different Asset Classes Across Economic Regimes

ERAA® looks at the relative rate of change between growth and inflation to define an economic regime, then makes informed asset allocation decisions. We’ve identified four distinct economic regimes, and built the appropriate asset allocations for each of them. (More on the different economic regimes below.)

Pillar II: Risk control 

There are occasions where the economic signals from Pillar I aren’t strong enough to suggest a clear regime. This happens particularly often during transitions from one regime to another. For example, if growth is 0.1%, is this “positive enough” to invest in a growth-oriented portfolio? If growth is -0.1%, would it be appropriate to switch to a defensive portfolio?

In the face of unclear economic data, ERAA® looks at the momentum (rate of change) of growth and/or inflation to see if there is clear guidance on direction. If the momentum isn’t solid enough to provide predictive guidance, ERAA® adjusts our clients’ portfolios to an All-Weather strategy until the direction of economic data is clear again. The All-Weather strategy is designed to simultaneously protect capital and perform well in uncertain economic conditions.

Pillar III: Valuation gaps  

ERAA® continually compares each asset class’s fair value to actual market valuations. When there’s a gap in the valuation, ERAA® adjusts portfolio asset allocations accordingly. So, if Asian equities were priced lower than the data suggest they’re worth, the system would adjust a client’s portfolio to have a greater allocation to Asian equities, to capture the asset class’s potential future value.

The chart below shows how ERAA® reoptimises portfolios to account for valuation differences. We can see that the actual 3-year total return for XLK (a US technology ETF) and ERAA®’s model expectation tend to trend together over time. However, they don’t track each other perfectly, resulting in a gap between actual and model total returns. This difference is known as a “valuation gap”, and is shown by the green line in the chart below.

StashAway’s ERAA® (Economic Regime-based Asset Allocation)

Pillar IV: Managing asset-specific risk

Pillar IV, introduced in November 2021, manages asset-specific risks in our portfolios. It sets asset allocation limits based on the historical relative performance of each asset compared to the portfolio’s benchmarks.

ERAA® constantly keeps track of an asset’s historical performance relative to the MSCI AC World Index and FTSE World Government Bond Index. ERAA® then adjusts the maximum allocation to each asset class so that any idiosyncratic drawdowns won’t have an outsized impact on our portfolios.

Should an asset outperform the benchmark indices by a significant amount, ERAA® ensures that allocation to the asset doesn’t breach the upper limit set by Pillar IV.

What are the 4 economic regimes?

We’ve identified 4 distinct economic regimes based on distinct relationships between growth and inflation.


Good times: Positive growth, low inflation 

When the economy comes out of a recession, and growth outpaces inflation, real growth increases. This is an ideal environment where the quality of growth is high.

Inflationary growth: Positive growth, high inflation

As the economy continues to heat up and inflation rises, the quality of growth starts to deteriorate. Here, investment returns from risky assets are also likely to be falling.

Stagflation: Negative growth, high inflation

When inflation is left unchecked and spirals out of control, it eats into growth. The economy goes into a combination of stagnation and high inflation, called stagflation.

Recession: Negative growth, low inflation

Falling wages tend to follow this cycle, which in turn affects consumers’ spending abilities. As prices of goods and services are falling, we have a recession with deflationary price pressure.

When does ERAA® reoptimise your portfolio?

ERAA® keeps each customer’s risk profile constant throughout any economic condition by systematically re-allocating assets when the economy or the markets substantially change. This process of proactively determining a new asset allocation target for any given portfolio is what we call “reoptimisation”.

Our reoptimisation feature protects customers’ capital by maintaining constant risk throughout different economic and market cycles. ERAA® monitors what economic regime is in effect, and leverages a multitude of different data to manage portfolios systematically, ensuring that asset allocations are always optimised for the given economic environment.

For example, when the economy moves from healthy growth to a recession, an optimised portfolio’s exposure to equities will decrease and its allocation to fixed income (bonds) and Gold will increase. In this scenario, the equity portion will contain more defensive sectors, such as consumer staples.

Ultimately, ERAA®’s goal is to maximise customers’ long-term returns while keeping volatility, or risk, at each individual customer’s specified level.

Reoptimisations are most commonly triggered by a change in the economic regime (Pillar I or II), but can also happen as a result of significant moves in specific assets (Pillars III and IV).

You can expect changes driven by changing economic conditions to occur every 3-7 years, and for the changes to the portfolio to be significant. In turbulent times (eg. the 2008 Financial Crisis), changes to a portfolio could happen more frequently. In fact, changes would have occurred multiple times within the year leading up to the financial crisis: there were four economic regime changes between November 2007 and February 2010.

ERAA® in practice: the 2008 Global Financial Crisis 

ERAA®’s systematic and economy-driven approach would have worked well in past financial crises. Let’s review how the 2008 Financial Crisis unfolded.

In the chart below, we can see that the US economy was moving from good times to inflationary growth as early as late 2007. This period was characterised by positive growth and an inflation rate that was higher than 3.1%.

1H2022 returns - economic regimes

6 months later, the economy shifted into stagflation as the subprime mortgage crisis dragged on growth. The first warning sign on growth came in May 2008 when US industrial production registered its first negative print of -1.0% year-on-year (YoY), even while inflation was still around 4.1% and rising. By the time Lehman Brothers failed in September 2008, US industrial production had deteriorated from -1% to a low of -8.3% YoY and the economy had been showing negative growth for 5 months.

Post-Lehman bankruptcy, headline inflation managed to stay around 5% for some time. It was not until December 2008 that the first negative inflation momentum was observed. After that, inflation started to dip rapidly. By February 2009, the US economy had shifted from stagflation to recession.

In brief, ERAA® would have spotted the first signs of trouble and started reducing portfolio risks as early as May 2008 when the economy went into stagflation. By December 2008, when negative inflation momentum was observed, our investment algorithm would have made another shift, from a stagflationary portfolio to a recessionary portfolio.

Looking back at the chart above, we see that an ERAA®-balanced portfolio would have significantly outperformed both the S&P 500 and the 60-40 stock-bond benchmark. The ERAA® portfolio would also have had significantly fewer drawdowns, leading to better performance after the 2008 Financial Crisis.

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