The global financial crisis and the impact on investment markets are still very fresh in people’s minds. This has been the most serious crisis for decades and in response, many investment managers have been questioning whether there are aspects of their investment approach that could be refined to provide their investors with better downside protection.

This is not an unreasonable approach because clients typically feel the pain of a decline in their portfolio value more than they feel the euphoria of a bull market. Extended and pronounced market declines such as those during the global financial crisis also provoke many investors to take decisions, such as moving into cash, that provide short term comfort but are ultimately wealth destructive in the long term.

This is why the industry is looking at ways to enhance risk management while still providing investors with opportunities for long-term wealth creation.

To help investors achieve their goals, investment managers typically determine a strategic asset allocation (SAA) to reflect the objectives, risk tolerance, liquidity needs, fee tolerance, liability profile, etc of their clients.  Defining this ‘neutral’ strategic asset allocation is still far and away the key decision for all investors because asset allocation accounts for most of a client’s return outcome and this should therefore be the foundation of any investment strategy.

However, the global financial crisis and the associated substantial weakness of markets have led investment managers to question whether slavishly maintaining a long term asset allocation is the best thing to do, especially when the manager has developed insight which leads them to be concerned about the potential downside risk of markets or low prospective return potential. Many investors have understandably been asking their investment managers why they didn’t foresee the global financial crisis or, if they did, why they didn’t do something to reflect those concerns?

In response, a number of investment managers are considering the introduction of what is commonly called a ‘strategic overlay’. This typically entails adjusting the asset allocation of a fund away from its neutral strategic weightings in response to extreme or worrying market circumstances.

However, the overlay should be applied within tight boundaries, say plus or minus 5 per cent, otherwise the asset allocation may diverge to the point where clients end up with an asset allocation which is very different to what they originally bought. Also, the timeframe under which the strategic overlay adjustments are to be applied should be medium term, say three to seven years, otherwise the investment manager will look more like a market-timer or trader rather than a strategic long-term investor – which is what their clients were presumably comfortable in choosing in the first place. Strategic overlay adjustments may also take three to seven years to pay off as well so clients will need to be patient.

A strategic overlay could be applied in a number of ways. Aside from adjusting the split between growth and defensive assets, it could also entail changing the allocations between global and Australian shares, allocations to developed markets versus emerging markets or even levels of exposure to different investment styles such as value and growth.

For most investors, their strategic asset allocation doesn’t stay the same through time. Investment managers typically ‘evolve’ the strategy as new opportunities arise, asset class characteristics change or in response to the investor’s circumstances as well. So, the introduction of a strategic overlay should be seen as just another stage in the evolution of clients’ investment strategies.

John Owen is an investment specialist with MLC

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