Jim Franks, director of investment consulting in Australia with Russell Investments, describes the market that his clients are confronting as “foreign in anyone’s experience”. Looking ahead, it “will be substantively different from what we’ve experienced in the last generation”. Funds have incurred losses in almost all asset classes, and the rigidity of long-term portfolio settings, which now demand rebalancing back into diminished equities portfolios, has made dynamic asset allocation (DAA) a subject of debate among investment committees in Australia.
For Andrew Lill, director of investment strategy in Australia with Russell Investments, DAA describes the process of “taking deviations from strategic positions on account of valuation signals” that suggest “the benefits of doing so overcome the risks”. The process usually manifests as tactical ‘tilts’, which vary in duration and risk exposures, away from strategic asset allocation (SAA) targets. As the financial crisis continues to harm institutional portfolios, core premises underpinning SAA such as appetites for risk, assumptions of returns and volatilities from asset classes are being reassessed. Even investment horizons are being questioned.
Schroder Investment Management implements a dynamic approach to SAA through a multi-asset fund (it believes the financial meltdown will create a renewed interest in these ‘balanced’ types of funds, given the sector specialist frameworks built by asset consultants have sometimes betrayed a lack of understanding of how asset classes relate to one another). The strategy is driven primarily by monitoring changes in the attractiveness of risk premia across the investment universe, and exposing the portfolio more heavily to these premia at opportune times in order to achieve a stated return. In this, understanding, managing and allocating risk is as important as understanding, managing and allocating sources of return.
The dynamic approach to SAA aims to counter the tendency of asset prices to, at times, deviate far from their averages and generate skewed returns. And since risk premia are never constant, allocating capital to achieve a specific return after inflation is a dynamic process. Rebalancing to SAA targets does not always provide exposure to the most attractive risk premia, and in the words of Schroder head of fixed income and multi-asset, Simon Doyle, can be a “redundant” strategy for a portfolio aiming for a decent long-term return above inflation. Doyle manages Schroders’ dynamic SAA strategy in Australia. He says risk premia do not usually change meaningfully on a short-term basis.
In recent years, his team has made four major adjustments to the portfolio’s asset mix to reflect medium-term return expectations. In 2006, investments in listed property trusts were wound up, and in early 2007, credit positions were closed down. In the third quarter of 2008, the portfolio took an underweight exposure to equities. Then, in late 2008, it returned to credit markets. “When you get big shifts in risk premia you need to make the change,” Doyle says. The latest tilt – scooping into double-digit yielding investment grade and high-yield credit – is spurring a lot of the DAA talk among trustee boards at the moment, says Russell’s Franks. But the key difficulty in executing successful DAA – accurate timing of portfolio tilts – is one reason why it is still an agenda topic, not a strategy.
“Investment grade bonds look especially attractive, but they did so 12, six, three months ago as well,” Franks says. “It’s appealing, but the question is: when do you move? You need to have some way of understanding that there’s not just an opportunity, but a timely opportunity.” Particular signals, such as credit spreads (which are high, but so are expected default rates) and weak indicators of economic confidence, need to improve before Franks would feel comfortable recommending a foray into credit to investors. Talk of the enduring viability of SAA, and the appeal of an ongoing DAA, has become a theme among many of Franks’ super fund clients. After “overwhelming” market events and collapses in asset prices, funds are examining the assumptions underpinning their SAA targets. Some feel they “must do something” to counter poor returns; others are sticking to their long-term aims to do their best to ride out the turbulence.
Still, among some clients, “the deviation from SAA has been pretty extreme”. “Market events have overtaken people and now they’re faced with difficulty in rebalancing back,” he says. “In some cases they’re considering whether they should change their SAA rather than rebalance.” Either through choice or the movements of markets, funds have been willing to temporarily “drift” from SAA targets. “The inability to rebalance has become almost a decision not to rebal- ance,” Franks says. “Many clients are letting this go until they can find some liquidity in the markets or have more comfort about how the global financial crisis is going to unfold.
At the same time there is a growing recognition that this isn’t an ordinary recession – people are going back to the 1970s, and even the 1930s, to get close to this.” Testifying his belief in the strength of multi-asset portfolios, Schroders’ Doyle says DAA challenges the prudence of equities-heavy SAA formulae designed to achieve long-term outperformance above inflation: “Is that 70 per cent allocation to equities correct given what they’re trying to achieve for their clients?” Some super funds are revising their SAA, questioning: “How did we get from 60/40, to 70/30?” Franks says. When the recovery comes, confidence returns and asset prices ascend, investors should mount a contrarian case to reassess portfolio construction, Doyle says: “Because when things are going badly there’s not much you can do about it”.
Like in mid-2008, when strong commodity prices and a high Australian dollar were among the major risks in the local index; a steep decline in value would destabilise the market and eventually affect cash rates. When this happened, the ASX turned down steeply, coinciding with global indexes, resulting in its worst bear market in 80 years. Implementing DAA to buy put options on the Australian dollar and long-dated government debt securities, before commodities prices and the Australian dollar caved, could have offset this risk. But not all investors made this play. Equities specialists, such as John Sevior, head of Australian equities at Perpetual, argue that, like in 1974 and 1930 – the only other years in which markets returned worse than negative 30 per cent – the asset class will recover, eventually.
Sevior points to historical returns, dating back to 1876, recorded in a blended All Ordinaries chart to show that in five of the seven years following 1930, the domestic index surged between 10 and 20 per cent ahead. After a terrible 1974, the market boomed, handing investors a 40 per cent return the following year. Yet brutal 2008, seen as “the mother of all bear markets if you take a 12-month view”, will not be followed by a sudden, sustained upswing like 1975, or years of relieving outperformance, like in the years after 1930, Sevior says: “There’s been a lot of bad news. It’s come, and there’s more to come.” “Investors shouldn’t be complacent because this is clearly a systemic event in global financial markets,” he adds.
“The consequences of what’s happened in financial markets are still to come to the real world.” Frozen corporate bond markets mean that listed Australian companies will be forced to raise between $10 billion and $20 billion from shareholders in the next few months, he says, and further earnings shocks, particularly for cyclical companies, are imminent. Making a strategic tilt away from equities then, or at least not rebalancing to portfolio targets set under SAA, seems logical enough. Roughly 90 to 95 per cent of volatility in most institutional portfolios comes from equities, Doyle says: “The more you reduce equity exposure, the more diversified your portfolio becomes.”
But allocating capital into different asset classes does not always offset underperformance from one part of the portfolio. Writing in a paper entitledManaging a CPI+5 per cent Portfolio,Doyle and Cooper state their preference “to concentrate on asset exposures, of which there are many, as distinct to asset classes, of which there are few, and understand the economic relationships between the two” in order to achieve diversification. They single out alternatives such as infrastructure, private equity, hedge funds and real assets as “trading strategies” or a “repackaging of an existing asset class – often with embedded leverage, reduced pricing frequency and, critically, higher fees”.
As such, these alternatives access underlying equity and credit risk premia. Investors, then, would be better off searching for “economic” rather than asset class diversification, Cooper and Doyle write. Some of the newer alternatives – as “repackaged beta” – have sunk in value when they should be resistant to the market direction. Economic diversification, achieved when “assets in the portfolio are doing different things at different times”, can better minimise overall risk, Doyle says. This disapproval of alternatives does not extend to the Future Directions funds managed by AMP Capital Investors (AMP CI). Last year, the manager changed the SAA of the fund so that it became “less dogmatic and more flexible,” David Dix, product specialist with the manager, says. The Future Directions Fund now aims to allocate 17 per cent of the portfolio to diversified alternative strategies, including private equity, infrastructure, opportunistic, commodities and funds of hedge funds. Catastrophe bond and TAA managers also feature in the lineup.
New mandates have been awarded to Asian infrastructure, private equity and catastrophe bond managers. “We’re going to move towards a more dynamic approach to SAA, where you see there being fundamental value in certain areas, be they currency, equities, fixed income. We have the ability to move away from longer-term SAA for a period of time,” Dix says. The moves require approval from the investment committee, and can take between six and 12 months, from research to implementation, to be initiated. This capability was supported by internal research and advice from AMP CI’s asset consultant Mercer, and prompted, in part, by client requests for more downside protection.
The essence of successful DAA is accurate timing. Even if an investor detects an asset bubble that appears ready to burst, they require incredible conviction to place their bet. The managers who profited from the subprime mess were at one point “paralysed in terms of their willingness” to implement their views, says Russell’s Franks. While the degree of benefit to any strategic tilt is always clear after the event, “when you’re in the middle of it, it’s not that obvious”. To succeed at DAA, institutions require governance processes that can act decisively and quickly, as opportunities can emerge rapidly.
The risks of implementing DAA must be carefully analysed, since the strategy can introduce more risk into the portfolio, and an exit plan must be set up. “What happens when the signal goes back to its mean?” asks Lill of Russell. The costs of implementation, which can involve redeeming investments in one asset class and allocating that capital elsewhere, should also be kept in mind. A thorough and accountable decision- making process for DAA, which includes working with consultants, is necessary.
Doyle says the organisational processes of super funds could make implementing DAA difficult: the necessary research, meetings, recommendations and approval judgments result in a lengthy process. But losses across portfolios have prompted funds to examine the assumptions upon which they have based their decisions to invest in assets ranging from equity long/short funds to sovereign bonds. “What did they think they were buying, and has that changed? Clearly a lot of things have come unstuck: that’s what risk is,” Franks says. “The market has almost imposed an outcome: you’re not forced, but inclined, to be more active about asset allocation. Where does that leave us? We’re in tricky territory when it comes to applying that thinking on an ongoing basis as opposed to [drawing on] what has happened in the last year. DAA is part of the discussion.”