Forget shuffling between equities and bonds. As the underlying causes of market volatility become more complex, so do the tactical asset allocation tools used to manage and exploit it. AMANDA WHITE and SIMON MUMME report.
The complexity and unpredictability of recent market movements are being reflected in asset allocation debates throughout the country’s superannuation investment committees. AustralianSuper, for one, is allocating all of its inflows in to cash, and chief investment officer Mark Delaney says that will continue until “we think there is a better place to put it”. While not aiming to hit a particular allocation target, the cash component of the $30 billion fund was sitting at 6 per cent last month.
How funds should react to the recent market turmoil is a question up for serious debate. At a recent Watson Wyatt roundtable, senior investment consultant, Tim Unger, said super funds reactions should be closely linked to their governance capabilities, their internal resources, skills and decision-making framework. “Only funds that have strong governance, and the ability to think through potential outcomes, should react at this time. The potential for regret – doing something that doesn’t turn out to be correct – is quite high right now.”
Clayton Sills, QIC business relationship manager – strategy, says recently QIC has sought to diversify some of its larger clients’ longer-term asset allocations away from listed equities into alternatives and unlisted assets such as commodities, private equity and infrastructure. “At the same time QIC’s concern with the valuation of listed equities for the last year has resulted in a reduced weighting to equity markets. The combined effect of the time required to gain exposure to appropriately priced unlisted assets and underweighting equities due to valuations concerns is a relatively high allocation to cash – a good position to be in during recent equity market volatility.”
But while it is a time for funds to be cautious, it is also a time of opportunity, particularly for skilled managers. While AustralianSuper has historically managed its cash in-house, Delaney also believes overlays can have an impact if they are big enough. Traditional tactical asset allocation funds have played with equities and bonds, trying to pick changes in the market and adjust the ratio accordingly, but the role of relative bond and equities allocations is diminishing both in a performance and risk sense.
BlackRock Investment Management believes the market is too extreme and unpredictable for such a traditional approach to TAA, particularly at times like now when both equities and bonds are volatile. David Hudson, who heads up BlackRock’s asset allocation alpha fund, a pure alpha play which in the past has been used to add value to its own balanced fund, believes asset allocation in an equities versus bonds sense would be particularly difficult to manage at a time like this. “How to manage risk of positions is crucial, the relationship between equities and bonds is a valid area to take risk in but not the only risk. Where asset allocation used to add value, our opinion is that is not a good bet to try and time the equity versus bond play.”
The BlackRock fund, which in the year to February has returned 48.77 per cent before fees, has a larger universe that includes foreign exchange, commodities, bonds and equities and also looks to take into account the importance of market momentum. “Traditional asset allocation would fight market momentum, we don’t want to do that, we are happy to play with the market,” he says. “Markets can go places you don’t think they can go, and we have respect for that. There are some good opportunities in the equities versus bonds space but if that’s the only quiver for your bow in times like now it is very difficult.”
The Blackrock fund takes the best investment views from the global funds management team and filters that together with whatever is working in the market at any one point in time. “Because this fund has concentrated risk we want to go with market momentum. We miss the turning point quite deliberately because we think we will have momentum going strongly the other way once it turns. Traditional TAA, trading off equities and bonds, tries to pick the turn,” he says. “We exploit those trends in a systematic way without putting all our money in, for example, bonds. In the past few years we have had risk in foreign exchange, commodities, and yield curves.”
Hudson says in recent times there have been a number of very clear market momentums: soft commodities, gold’s two big years; equity versus credit; steepening of the yield curve; downward pressure on the US dollar. BlackRock’s risk positions come in two halves: three directional risk strategies which are equity versus cash, bond versus cash, and commodity versus cash. Then there are six relative value strategies: equity versus equity, equity versus bond, equity versus commodity, bond versus bond, foreign exchange, and foreign exchange versus commodity.
And while the identified themes are quite long lasting, for example the yield curve steepening view has been that way for about 18 months, management of those positions is dynamic with daily active trading.
New ways to find and exploit risk
While short term fluctuations do affect returns, volatility also creates opportunity. In a business sense this has certainly been the case for Apostle Asset Management, which amongst other represents the US-based hedge fund-of-funds manager, Harris Alternatives, in the Australian marketplace.
Apostle’s investment director, Debbie Alliston, says that by the time $50 million in commitments outstanding at presstime is drawn down, Harris’ Australian clients will have topped up their existing investments to the tune of $280 million since the start of December. Harris’ two products offered here, a multi-strategy hedge fund-of-funds with 55 underlying managers, and a newer vehicle with 32 long/short managers, now run over $1.8 billion sourced from Australia with REST, Cbus, CARE Super and JANA’s implemented consulting arm the biggest clients.
Alliston sensed that the top-ups were mostly coming from cash, and reflected funds’ current lack of confidence that long-only equity mandates could generate real returns. “Year to January both the Harris funds have done over 8 per cent after fees, while the S&P and the MSCI World have been negative. There’s a lot of funds and consultants which are basically doing ongoing searches for good hedge funds investments at the moment,” she said.
Alliston noted that the demand for quality hedge funds had been drastically exceeding supply until recently, when a new wave of start-ups has helped even up the equation. “It’s the sign of a maturing industry. We had the first wave of hedge funds which was guys coming out of the proprietary trading desks at investment banks, now we’re seeing the second wave, where people who’ve risen through the ranks of a hedge fund to be 2IC are going out and setting up on their own.” Beyond tactical tilts to hedge fund-of-funds, tactical asset allocation is now common in the form of global macro mandates which QIC employs in a multi-manager, multi-strategy form with both internal and external management.
Managing director of QIC active management, Jim Christensen, says generally global macro managers are finding the present conditions difficult. “There are certain aspects they have had trouble with, for example, currency or relative equity. In the last year or so fundamental based macro strategies have struggled,” he says. Diversification overcomes this, and QIC, like Blackrock, employs between eight to 10 different risk strategies. “Equity versus bonds is such a small part of risk budget, and we have diversified away from that to a broader range of strategies,” he says.
Christensen says few, if any, products are like the traditional tactical asset allocation where all of the risk is around directional equity. Now all global macro hedge funds broaden their asset pool. “Taking a lot of risk in directional equities and bonds can be very rewarding but also very risky. TAA is now a very diversified bucket of risk, we have relative equities and relative bonds, directional equities, directional bonds, currency global and regional, volatility, and technical strategies such as trending environments.”
About a quarter of QIC’s overall risk budget is in broad macro overlays and Christensen, like AustralianSuper’s Delaney, says a high allocation is necessary to make it worthwhile. He argues that any added risk in alpha is small compared to the overall risk funds may have in directional equities by owning shares outright. “We try to increase the level of active risk in everything we do. To make it meaningful you need to run at quite high levels of risk,” he says. “With equity and bond market risk the volatility can be quite high compared to alpha. If for example you have 60 per cent of your money in the stock market it will be a big influence on the portfolio.”
Gavin Watson, the head of institutional business strategy at RiskMetrics Group visiting Australia recently from New York, believes the return of volatility is shifting the focus of global funds, and managers, from return chasing to risk management.
He says the market shake out is showing up hidden concentrations of risk that can be seen when a total portfolio approach to risk is applied. “For example financials have been so battered they may present an opportunity but if that opportunity is being taken in bonds and equities then you may be overexposed in a total portfolio sense,” he says. “The large super funds are trying to untangle all the relationships. Silos are convenient but they don’t show the relationships.” Watson says looking at trends over time is very powerful.
“You can look at say small cap managers, and what the risk contribution is to the total portfolio, and whether that is increasing or decreasing relative to a static allocation. Funds then can ask: ‘Do we change the allocation because the whole underlying market is changing out of our risk budget tolerance’?” The RiskMetrics software, which is a forward looking risk measure using the current volatility of market and current relationships has been used prevalently by the larger funds around the world.
“This is an interesting time, this return to volatility, and people who have put these tools in place, are justifying they have done the right thing. It is prudent to put it in place,” Watson says. “There is no one way to measure and manage risk and the best risk managers are moving towards stress testing rather than passive measurement.”
Watson believes the art form of risk management is stress testing, which involves testing in advance the strength of investment relationships. “It tests relationships you wouldn’t think would be broken but that may trigger events across the total portfolio,” he says. “Everyone thinks risk management is about how to reduce risk, some times it is an encouragement toward not spending the budget.”
By aggregating each position across the portfolio from the bottom up, and giving the portfolio a common language for risk, the software allows funds to have a single view of risk and reveal hidden concentrations of risk. “You need an independent way to look at, for example, whether hedge funds are all moving in the same direction. Silos are convenient but they don’t see the relationships,” he says. “Multiple exposures might be all tilting in the same way, and funds can look at an overlay technique to balance that.”