Asset Allocation is back – but what do you do about it?

With a significant divergence of returns for the Australian share market and other major markets since the late 1990s, and helped by some sophisticated new product offerings, there has been a renewed interest in tactical asset allocation (TAA) strategies.

Two presenters in separate sessions at the recent ASFA conference put the case for the increasing attention to both TAA and strategic asset allocation – Michael Karagianis, the senior asset allocation strategist in the new Global Investment Solutions unit of UBS Global Asset Management and Simon O’Grady, head of asset allocation at Suncorp Investment Management. While the strategies suggested by the two funds managers differ, they both have the same fundamental principle driving them – diversification of risk. In UBS’s case, TAA is made all-the-more attractive because of the firm’s sombre view of the Australian share market. UBS believes Australia is 15-20 per cent overvalued. The probability of Aussie shares delivering negative returns in any of the next three years is 70 per cent, compared with only 50 per cent for global, ex-Australia, shares. The most undervalued markets in the UBS model are the US and UK. “So why not shift the beta (market return) and leave the alpha?” Karagianis said. Suncorp’s O’Grady, on the other hand, says that the risk to a fund of substantially underweighting Aussie equities and getting this wrong – 30 per cent on the UBS valuation – is too great for a fund to bear. “A fund should not put its long-term risk/return objective at risk,” O’Grady says. The strategy proposed by UBS – called ‘dynamic alpha’ – mixes the two strategies of porting alpha and traditional TAA. Kariagianis said porting alpha by itself was inflexible with the beta (you still have the same market exposure even though you may be getting market outperformance from another asset class), while TAA was inflexible with the alpha (traditional TAA products usually gaining market exposure through futures or index funds). Using these strategies a manager can construct a portfolio with quite a defined target return and risk profile. For instance, one UBS portfolio had a 7 per cent target real return (after inflation), which was comprised of 2.4 per cent from cash, 2 per cent from market-neutral strategies, 1.85 per cent from stock selection and about 1 per cent from currency management. “This looks to produce similar returns as those of a balanced fund but with the risk of a bond fund,” Karagianis said. Asked whether it was likely that any Australian super fund would go to zero in Australian equities, Karagianis said: “My fear is that we could get to 30 per cent overvalued (for Aussie shares) within the next year. Early this year we started to be cautious … and at the end of September we moved to be significantly underweight Australian equities and overweight international.” He said that the resources boom fuelled by Chinese demand “sounds a lot like the dot com bubble to me”. Suncorp provides what it terms “new-style TAA”, more frequently known as “global macro”, to large clients. This differs from the old-style TAA in two key respects: • Expansion of breadth – whereas old-style TAA overlays were restricted, effectively, to making two-five bets a year, the new funds and trust products, which allow leverage, have eight-nine independent risk/return streams for which they can lay those bets; • Targetting risk – the new funds are managed so that they target a fixed constant risk – which is easier to predict than returns. In Suncorp’s case, it targets a daily risk of 1 per cent. New-style TAA products do not have the same bias towards domestic equities and bonds as the old strategies, however, O’Grady believes that big super funds are more likely to use them as alpha-seeking strategies for small proportions – say 10 per cent – of a portfolio, rather than replacing the major parts of a portfolio as some US endowment funds have done.