Andrew Yap says investors are gaining a renewed appreciation for the long-term power of asset allocation.
The financial landscape facing investors continues to be rocked by various factors, including a deteriorating macroeconomic outlook, challenging market conditions and a strained global financial system. These external influences are translating into more volatile and less certain asset class returns. By implication, more extreme conditions are proving to be a challenge to portfolio construction, particularly among those investors adhering to a static and constrained approach to asset allocation.
As the market looks set to continue into uncharted territory, it is understandable that managers employing more active asset allocation strategies have gained popularity. This has particularly been the case for those investors looking to take advantage of existing market conditions while also controlling downside risk.
At a time where bottom-up manager selection has become an increasingly difficult task, such an approach is further justified by recent industry studies showing that active asset allocation coupled with prudent strategy selection can serve to meaningfully enhance portfolio outcomes.
As an investment practitioner, it has been interesting to observe the recent extension of investment strategies and the evolution of new capabilities that seek to take advantage of the increased volatility following the GFC. Through the incorporation of strategic tilting and overlays, and tactical and dynamic asset allocation (TAA and DAA), investment managers have sought to move beyond the more traditional strategic asset allocation (SAA)-only approach to portfolio construction. By building increased flexibility into investment mandates, these new-breed offerings seek to overcome some of the constraints of the SAA “set and forget” approach, while also catering for an increasingly diverse and risk-aware investor base.
While acknowledging that the SAA approach currently remains a vehicle of choice among many investors, it is understandable that this format continues to become less mainstream, particularly in an environment of more disparate asset-class returns. However, to better illustrate why this may be so, it is necessary to understand what is meant by SAA, the limitations inherent in this methodology and to consider how market innovation is seeking to overcome these perceived shortcomings.
SAA what?
The most commonly understood approach to asset allocation remains SAA, which resulted from the mean-variance optimisation approach postulated by Harry Markowitz. Often referred to as a “static” approach, it is employed by managers seeking to offer the market a plainer product, in which portfolio positions are anchored across asset classes in a fixed ratio. Managers adhering to this approach generally take a longer term view, diligently subjecting portfolios to relatively tight investment constraints and stringent rebalancing policies to preserve their asset-class mix.
However, traditional SAA has faced a number of criticisms, stemming from its long-term approach. Commonly cited criticisms are that risk-return assumptions are too backward looking, targeted asset-class exposures are only subject to periodic review (every two to three years), and subscribers to this approach are often slow to incorporate significant market effects.
Background
In an attempt to overcome the perceived shortcomings of traditional strategic asset allocation (SAA), an increasing number of managers have sought to relax some of the constraints inherent in the SAA-only strategy. One approach has been to incorporate shorter term assessments and provide investment managers with a degree of flexibility in moving portfolio positions away from their neutral allocations. Through either intended asset-class drift, the redirection of cash flows, or use of derivatives, managers have been granted limited discretion in “tilting” portfolio positions away from targeted asset-class positions to take advantage of existing or forecast near-term market conditions.
An extension to this approach has been the incorporation of tactical asset allocation (TAA). Through a more frequent assessment of asset-class assumptions, portfolio managers are permitted to take larger active bets away from their SAA. TAA is an approach that has continued to gain momentum recently, as it seeks to take advantage of near-term market mispricing in a structured and methodical manner. While proponents of this approach continue to believe in the longer term merit of an SAA (which over the long term is expected to drive investment outcomes), they also believe that TAA can serve to provide downside protection while being a source of incremental alpha.
Amid the proliferation of new investment strategies, discrete sub-asset classes and an increasingly sophisticated investor base, a number of unconstrained investment capabilities have begun to filter into the domestic market. Largely focused on generating more specific and targeted investment outcomes, these funds are dynamic in approach.
Portfolio positioning is not subject to a SAA; instead, it is determined through a continuous assessment of investment markets, with portfolio managers having near-full discretion in setting asset-class exposures. By implication, accountability in setting an appropriate asset mix shifts from the investor to the fund manager. In a more volatile world where valuations and risk can change significantly over a short period, placing this allocation decision with investment specialists has clear advantages. They constantly monitor investment markets and can implement change without constraint.
What DAA?
In considering the relative merits of DAA funds, investors must feel comfortable that portfolio positions can rotate quickly and meaningfully between asset classes, and from one period to another, in adapting to current and forecast market conditions. As a consequence, this may necessitate a material exposure to growth, income or alternative asset classes, the mix of which may on face value appear inconsistent with an investor’s risk-return preferences. While this may be true given a point-in-time assessment, it is important to be aware that such moves will be made with regard to the sole purpose of these funds – namely to deliver on a stated investment objective.
While acknowledging that there are strong arguments for DAA, it should also be noted that products based on this approach are still relatively new to the retail space. DAA products are currently offered by Schroders, Perpetual and AMP Capital; however, a long-term track record for all of these strategies is not currently available.
This may prove a constraint for some investors who gauge strategy success on the delivery of stated objectives. While this measure of assessment is reasonable, it can be argued that successful DAA funds are most likely to be led by high-calibre portfolio managers who are supported by a skilled and experienced investment team (which preferably forms part of a global franchise), have a durable yet flexible investment process and maintain a multi-faceted risk framework.
As asset-class volatility threatens to be a more permanent feature of investment markets, it is within the DAA space that further investment products are likely to emerge, particularly with regard to objective-based absolute return and income-orientated strategies. With regard to the former, these are likely to appeal to investors seeking a total return solution and may be used as an alpha extension strategy. Conversely, income strategies are likely to gain appeal within the ever-growing retiree market and among more conservative investors reliant on regular and relatively consistent income streams.
Even though these products are relatively new, DAA strategies are likely to continue to gain in popularity. This can be attributed to investors once again being drawn to asset allocation as an alternative and more enduring source of return and risk management. And, with heightened levels of market volatility expected to remain in the near term, further derivatives of this approach are likely to emerge in meeting the needs of a diverse and risk-aware investor base.
Andrew Yap is an analyst with Standard & Poor’s Fund Services
