Dynamic asset allocation, enhanced asset allocation, strategic overlay, stractical investing: call it what you like, there’s a new kid on the block and it’s occupying the minds of super funds, asset consultants and funds managers alike. With super funds beginning to value downside protection more than incremental return, asset consultants and multi-managers have seized the opportunity by offering a service that moves away from “set-and-forget” strategic asset allocation (SAA) by taking intentional tilts over a medium term time horizon. KRISTEN PAECH reports on the investment phenomenon that has given consultants a new lease of life.
It has almost become irresponsible for a super fund to set and forget its strategic asset allocation, according to Fiona Trafford-Walker, managing director of Frontier Investment Consulting. Using a rollercoaster analogy, Trafford-Walker says the idea of a fund strapping itself in and hoping for the best does not make sense any more. “If you’re well strapped in and you’ve got a good stomach, that’s fine, but if you’re not well strapped in and you’ve got a weak stomach then it’s not fine, and the thing with a rollercoaster is you can’t get off in the middle,” she says.
Frontier has been actively managing clients’ assets for about 10 years, according to Trafford-Walker, but has only recently begun labelling it dynamic asset allocation (DAA) in response to the jargon’s entry into the investment lexicon. She says the last 12 to 18 months, in which super funds suffered unprecedented declines in assets under management, have highlighted to the market that there is “probably a better way to think about managing your asset allocation”.
She points to a wave of new request for proposals (RFPs) for dedicated asset allocation advice, including setting the strategic asset allocation (SAA), investment objectives and policy work and subsequently carrying out quarterly market reviews. “You are finding more funds talking about [DAA]; we’re doing more RFPs for asset allocation services, for example – we never did those before,” Trafford- Walker says. “We prepare a quarterly market review and that goes out to every client so they can check: are we on track to achieve our objectives?
What are the risks that are starting to exist that we need to do something about? Now funds are looking specifically for that sort of support.” Simon Calder, principal at Mercer and member of its DAA team, which is led by David Stuart and counts the NSW-based Energy Industries Superannuation Scheme among its clients, agrees the period of set-and-forget is now largely behind us. He says the traditional SAA approach relied on a confluence of very favourable financial and economic conditions – the so-called “great moderation” of diminished cyclical volatility.
“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.
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.
Chee says markets are going to be mispriced from time to time, since nothing ever sits at fundamental value, and funds should act to capitalise on that. “We think investors can take advantage of medium-term pricing over a three-to-five-year timeframe and generate excess returns in that way,” he says. “It’s a three-step process. Assess the economic trends; assess fundamental value; and then assess whether the deviation between fundamental [value] and market pricing is sufficiently large enough that you have confidence that you can take a DSAA position within your portfolio. In that regard we see DSAA as high conviction, relatively low frequency events.”
Seizing the DAA
Asset consultants are keen to stress that the evolution of DAA is not an exploitation of the events of 2008, although it’s unlikely that none of the proponents is motivated by financial incentive. Most claim to have been giving clients DAA-type advice for a number of years and say the recent promotion of the service is in response to client demand for a formalised DAA framework. JANA Investment Advisers, for instance, is probably most recognised for encouraging client funds to make significant shifts in asset allocation, often against the trend of peer funds.
It was well underweight international shares, for instance, in the late 1990s and the funds wore some pain before the tech bubble burst and the decision was finally vindicated. It has also advised against any listed property trusts for the past seven years. “We have always done it,” says Ken Marshman, JANA’s head of investment outcomes, “it’s more a matter of terminology”. However, for some time now, consultants have been on the back foot as super funds have built bigger in-house investment teams and moved away from the traditional retainer model towards specialist consultants, often assembled into panels and paid for one-off projects.
As funds increase in both size and sophistication, they are increasingly looking for specialist knowledge, and consultants have come under pressure to revamp their advice offerings to cater to this trend. The advent of DAA as a new asset allocation tool provides an opportunity for consultants to reaffirm their role as holistic adviser. JANA’s Marshman, says investors need to be wary of “fad diets”. DAA had a bit of a flavour about it of being a fad that would save investors in the future, because it would have in the recent past, he says.
“Investing is about having a balance of views. If you concentrate on one aspect you can avoid seeing the big picture and the new opportunities. (DAA) is just one of the tools in the armoury of sensible investing,” Marshman says. “Investing is about finding opportunities and avoiding risk. None of this stuff should be a religion. You don’t have to do something every day. Frontier’s Trafford-Walker believes some firms have responded to DAA from a business imperative perspective, but says the renewed focus on asset allocation is a welcome development.
“When you’re a money manager or implemented consultant and your funds under management have gone down 20 per cent, your revenue has also gone down by 20 per cent, so you do need new sources of revenue and this looks like an easy thing to do,” she says. “But we would say: it’s just not that easy and from a client’s perspective they want to be certain the people they choose to do this for them have the right credentials. Getting your asset allocation right is one of the most important things a trustee group can do and it seems to me that more money spent on that versus picking managers and paying managers [is] a pretty good deal.”
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