“Through the previous two decades, every time an economy was confronted with a recession, central banks were able to cut interest rates and happily the private sector responded by taking additional debt on to balance sheets,” he says. “Now, there’s recognition that simply adjusting interest rates is no longer as effective in minimising cyclical volatility as it was in the previous two decades. “We’re moving to a period where most people anticipate more cyclical volatility, and SAA is typically based on an assumption that most asset classes are in some sort of equilibrium.
That’s clearly not the case. Valuations and returns can move away from equilibrium for prolonged periods of time, and it doesn’t make sense committing new funds into a significantly overvalued asset class.” DAA is in contrast to the old strategic way of investing, where funds set their SAA and normally reviewed it every one to three years, or zealously stuck to their target weights no matter what. While processes vary, DAA ‘tilts’ are usually measured over a three to five year time horizon, and involve a deliberate move away from the SAA where it is perceived that there is an inherent emerging risk or opportunity within the portfolio.
The process is intended to complement, rather than replace, a fund’s SAA by providing an additional, mid-term timeframe in which to provide investment targets. Unlike tactical asset allocation (TAA), which is predominantly about enhancing returns and usually involves frequent, short-term bets, the overriding focus of DAA is risk management. But DAA is not just about a medium- term time horizon. It will usually also involve tightening the bands within which a fund will look to rebalance the portfolio after significant market moves.
This should provide an additional ‘volatility premium’ for the fund. If, say a fund’s SAA process included automatic rebalancing when the market moved up or down by 10 per cent, the fund would miss out on taking profits whenever the market rose by less than 10 per cent before falling back. Reducing the band to 3-5 per cent therefore provides more scope for rebalancing to add value overall (assuming trading costs are not too severe).
Susan Gosling, head of capital markets at MLC Investment Management, says while MLC’s Strategic Overlay does not directly target returns, the focus on risk should ultimately lead to better return outcomes. MLC has recently made the overlay available across all of its diversified strategies, having applied it to its Long Term Absolute Return Portfolio (LTAR) since December 2004.
