According to a recent paper by MLC Implemented Consulting, the asset allocation shifts enacted using the strategic overlay, which aims to manage downside risk more effectively while acting selectively to capture asymmetric payoffs, have added 7.5 per cent per annum above LTAR’s ‘neutral’ SAA since inception to the end of June 2009. The overlay is based on MLC’s scenario analysis approach and takes into account a broad set of around 40 more ‘generic’ scenarios, plus a focussed set of medium-term scenarios that specifically examine the potential evolution of the current environment.
Given the complexity of today’s economic environment, Gosling says there are currently a relatively large number of scenarios being considered, ranging from ‘new bubble’ through to ‘new crisis’. She says MLC recently added ‘re-regulation’ to the list of generic scenarios and removed ‘financial deregulation’, since deregulation was not deemed relevant in the foreseeable future. While supportive of a focus on risk rather than return, Gosling says it’s important for the industry to continue questioning its methods, adding that there are fashions in the investment industry as there are in any other industry.
“The recognition that risk varies through time and is sometimes high means that a more flexible approach to asset allocation is needed, but there are also dangers of a slide back into old return-chasing habits,” she says. “The best way to avoid that is to focus on risk and control exposure to adverse events.” That’s not to say that DAA can’t serve both purposes.
Watson Wyatt believes super funds should allocate between 5 and 15 per cent of their risk budget to “dynamic strategic asset allocation”, or DSAA (its own catchphrase), for a three-or-more-year timeframe and expect an increase in returns of 1 to 1.5 per cent per year above the strategic allocation. Jeffrey Chee, investment consultant – regional asset allocation specialist at Watson Wyatt, suggests funds adopt a tracking error relative to SAA of between 2 and 4 per cent as a result of the DSAA process.
A net information ratio (the ratio of excess return to tracking error) in the order of 0.25 to 0.5 per cent is appropriate, he adds, resulting in the expected excess return of 1 to 1.5 per cent. Examples of decisions taken for DSAA include: exposure to a specific sector, such as investment grade credit; new niche risk premia, such as catastrophe bonds; to benefit from macro themes, such as emerging market growth; to provide downside protection in a market bubble; to exploit pricing anomalies; and, to invest in new asset classes, such as carbon credits.
