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.

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