Jeff Mitchell says the global financial crisis (GFC) highlighted a flaw in the strategic asset allocation model that may be addressed with a less static approach to investing.
While there is a range of different methodologies available, portfolio construction in the Australian market has been dominated historically by the strategic asset allocation (SAA) model. However, the recent global financial crisis highlighted a flaw in the SAA model – in extreme economic conditions, diversification across asset classes to mitigate risk largely failed as the historical correlations of as- set class returns broke down, particularly in growth assets. This resulted in investors experiencing significantly greater-than-forecast drawdowns in capital.
With more Australians entering retirement and requiring access to capital, these drawdowns have led to the traditional static SAA portfolio construction methodology being questioned. Would dynamic asset allocation (DAA) be more effective in meeting investor objectives?
SAA VERSUS DAA
The SAA model is predicated on static relationships between the return characteristics (correlations) of asset classes.
‘With more Australians entering retirement and requiring access to capital, these drawdowns have led to the traditional static SAA portfolio construction methodology being questioned‘
These static values are drawn from the long-term (20 years and more) correlations between asset class returns and as such are relatively static. It comes as no surprise that over time the correlation of returns between one security/asset/asset class and another fluctuates due to economic events, asset valuations, and investor sentiment. So, while the long-term mean correlations underpinning SAA may hold, there will be extended periods over the short to medium term where the relationships and valuation factors will significantly differ from the long-term values.
An alternative methodology that incorporates the dynamism of these relationships and economic factors, and which is receiving increasing support as a preferred portfolio construction methodology, is DAA. This can be described as optimising the prospect of the portfolio achieving its objectives at a given point in time and has a strong alignment with an investor’s needs, regardless of life stage. Although DAA is objectives-based, it recognises the historical return relationships between assets and asset classes. However, it is more focused on shorter time frames (between one and 10 years) and importantly is forward-looking.
DAA starts with a consideration of economic and market factors and valuations to develop an outlook. It also develops expectations for returns and correlation of returns of assets/asset classes to arrive at the optimal asset allocation to achieve the investment objective. The forward-looking element focuses on capital markets inputs. Capital markets analysis is not an exact science but is integral to the DAA process as it provides the key inputs. Consequently, the capital markets capability needs to be robust, well-resourced, and operate with a defined and proven framework to ensure that the outputs are rigorous and valid.
The capital markets inputs also consider market factors such as credit risk and default probabilities, level of corporate earnings, earnings growth, relative value of securities and asset classes to risk-free rates, and historical levels relative to each other. DAA focuses on determining the relative attractiveness of markets, assets, and asset classes at a point in time for a given outlook, as risk premiums are not constant. In addition, some DAA programmes consider investor sentiment.
Valuation is also a critical factor and is a fundamental bottom-up part of the process. The fundamental difference between SAA and DAA is that SAA is more static, whereas the DAA process is by definition dynamic – outlooks and expectations, and consequently asset allocations, are amended as circumstances change. The final output of the DAA process is a point- in-time portfolio asset allocation, identified as optimal to achieve the particular investment objective.
IMPLEMENTING A DAA METHODOLOGY
Applying a DAA methodology in an environment domi- nated by SAA portfolio construction provides its challenges. Firstly, it can require more resources to administer – accessing or deriving adequate capital markets input can be costly. But with the substantial majority of portfolio returns being related to asset allocation, and capital markets representing the key input into the process, it should be allocated proportionate resources.
DAA requires additional rigour at the advice level in terms of both “knowing the client” through client objective identification and setting, and “knowing the product”, which is more complex and dynamic. This also has implications for traditional risk profiling outcomes.
This difference is particularly relevant for pre- and post-retiree clients who are moving/have moved into the drawdown phase, where their objective is heavily skewed toward effectively satisfying liabilities for the extent of retirement and away from investing in accordance with a static asset allocation determined by a risk profile.
The self-funded retiree proposition is particularly relevant as the effect of a larger-than-expected capital drawdown exposes them to the risk of reduced returns. They are largely or solely dependent on capital to generate their income, and pension payments usually comprise an element of capital – so the prospect of capital recovery is substantially lower than that of an accumulator who is still making contributions and not drawing on capital.
For DAA to be implemented effectively, there needs to be central control over the investment process as the portfolio and its asset allocation are heavily dependent on the quality of the process. This could result in advisers needing to outsource cer- tain elements, or portfolios having a greater reliance on a single manager product, even though there may be a range of different strategies underlying the product or portfolio.