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.” Russell Investments is one of a number of firms to recently launch a medium-term asset allocation strategy; however, investment strategist Andrew Pease says the team’s been working on the Enhanced Asset Allocation (EAA) service for the last decade.
Bringing together the “strategic tilting” process Russell applies across its diversified funds, and the ‘informed rebalancing’ service it has been providing to US institutional clients, EAA provides a disciplined approach for investors to respond to unsustainable market movements. “This shouldn’t be seen as a reaction to [the GFC],” Pease says. “We’ve been working on this since early 2006, when I joined Russell, and the team’s been working on it for the last decade.” Any fund embarking on a DAA path must be clear about their adviser’s philosophy on market timing and their process and decision-making framework for doing it, Pease says. “It’s not about picking the adviser with the most sophisticated valuation model,” he says. “The most important thing is understanding the underlying discipline.” Trafford-Walker says there’s a huge opportunity for consultants to make a big difference to member portfolios if they can get DAA right, but it’s not an easy skill.
“It worries me a bit that there are loads of people in the market now saying: ‘we do DAA’ when they’ve not done it before,” she says. “People want to be careful, because it’s a very different skill set. It’s not like going out and picking managers.” Despite the well-known fact that it is a fund’s asset allocation, rather than the manager selection, which drives the overall return, the superannuation industry has traditionally focussed heavily on manager selection and asset class construction – particularly Australian equities – within the portfolio. Simon Doyle, head of fixed income and multi-asset at Schroders, says directing some of the super fund’s research budget to thinking about the proper alignment of the asset allocation of the portfolio with the fund’s investment objectives is time and money well spent. “If we can get 10 per cent better at getting the positioning of the portfolio right it will have a much bigger impact on the performance of the portfolio than getting the manager selection slightly better,” he says. However the industry’s historical focus on stock and manager selection has left a gaping hole in the talent pool, Doyle says. “There are not a lot of institutions and people within those institutions that have the ability to do [asset allocation],” he says.
“You need to be good at building portfolios across assets. Lots of people are good at building equity or debt portfolios, but not a lot of people have an understanding across a broad array of assets and are able to manage risk within that context.” Trafford-Walker says that in many ways, it’s like going to a surgeon for a specialist operation. “You want someone who’s done this before because if you get it wrong it can have a big impact on the portfolio,” she says. “A decision to change your asset allocation even by 5 per cent to and from equities will make a huge difference, for example.” The big question for many funds when deciding to implement DAA is who should take responsibility for the task: consultants, specialist managers, fund staff or investment committees? Ultimately responsibility always lies with the investment committees and trustees to deliver the best possible outcome for members, but Robert Swift, head of multi strategies at BT Investment Management, says there should always be a threeway communication between the consultant, fund manager and super fund.
“The trustees should understand what they’re getting themselves in for with respect to the risks they’re going to be taking on; the consultants should be there to make sure that the board understands what they’re doing and the manager is being given clear instructions on what is and isn’t permissible; and the manager should be responsible for the return and managing the risk,” he says. “A functional investment process would allow all three parties to jointly participate in setting the expected return and risk framework. “The accountability for delivering performance rests with the manager. The accountability for setting the framework for risk lies with the people who own and are responsible for the assets, which is the trustees of the fund. That accountability is much greater and clearer if the trustees understand through a dialogue with the manager and consultant what they believe is the likely market environment of the future.” The difficulty with delegating the DAA decision is the tendency for funds to have multiple consulting relationships, rather than one adviser that oversees the entire fund assets.
For small funds without significant inhouse capacity, outsourcing is the only real option, although consultants highlight the need to have one key DAA decision-maker within the fund, preferably the CIO. “We have no problem at all being in a multiple consulting relationship but you just need to make sure that there’s someone at the fund who can coordinate all of the views,” Trafford-Walker says. “I describe that person as a master puppeteer; all the advisers are the puppets and you need someone back at the office who can coordinate or bring us together. That’s why you’ve seen more of these specialist providers come in on asset allocation rather than everyone having multiple general consultants.” Chee believes independent global consultants like Watson Wyatt are well placed to meet the DAA needs of super funds, given their ability to leverage global asset class research and their lack of bias towards specific asset classes.
“Any DAA process requires multiple inputs, you absolutely need to seek multiple views and even for clients that we advise on DAA we encourage those clients to seek multiple views as well,” he says. “Consultants can be a critical input to a DAA process but at the same time, for clients that can’t run that entire process internally, there is certainly scope for consultants to take responsibility for making some of those decisions, should the key stakeholder see that as a value adding proposition.” One model that Watson Wyatt uses for a large UK pension fund clients is best described as a partnership between the consultant and the fund. The fund has an internal asset allocation committee that meets on a monthly basis and Watson Wyatt consultants attend that meeting. “We take our analytic support and we discuss our views based on that analytic support to help them make decisions,” Chee says. Another model he envisages working for funds without the internal resources is to delegate the decision-making process to an external party, such as an asset consultant. Given DAA is mediumterm in nature and requires significant mispricing to be confident of deriving value over time, Chee says the views taken are likely to be high conviction and low frequency in nature.
“As a result I think consultants are well placed in that regard to form views and to provide input,” he says. “Consultants can take a longer term view on things and…in the normal course of events, any consultant running a DAA process should be showing a neutral view across asset classes. Managers, for historical reasons, are always expected to have active views so the timeframe tends to be shorter when looking at manager performance and manager activity.” Mercer’s Calder says he has a number of smaller clients that don’t have an investment committee and in these circumstances the funds management capacity falls to a broader finance committee. “For those smaller clients they’ll be looking to Mercer to essentially drive the process and they’ll respond to our recommendations, but if you were to go to the other extreme and consult a more sophisticated client, it would be more of a partnership between both the investment committee and Mercer,” he says. Doyle claims there is a case for DAA to be set in a single structure and delegated to a fund manager.
“The reason is, the way the governance structures work within a lot of institutions it’s difficult for them to implement change at an asset allocation level in a timely manner within the portfolio,” he says. “Outsourcing all or part of that decision improves the ability of the fund to capture those shifts in risk premium. If it’s internalised, the difficulty is making the changes.” However not all funds are convinced of the benefits of DAA – or outsourcing the asset allocation decision. HOSTPLUS does not do DAA, nor does it automatically rebalance back to its SAA targets. Rather, the fund is happy to let its position drift from the SAA for long periods of time where it believes there is merit in doing so. “We don’t do DAA in the sense that we don’t give it out to a third party to do and we don’t have anything that’s programmed or prescriptive but we are happy to move away from the SAA when we see value in certain asset classes over others,” says Sam Sicilia, chief investment officer at the fund. “Those moves ought to be few and far between and we have to have a certain degree of conviction in order to do it.”
Sicilia sees DAA as a variant of global TAA, but says trustees and trustee boards typically don’t have the skills to do either process themselves, forcing them to delegate to a provider. “Our view is that we would rather have very few intentional tilts away from SAA, so do it rarely,” he says. Sunsuper rebalances its SAA on a daily basis, but adopts more of a tilting strategy whereby its managers have discretion to tilt the portfolio where they feel the markets are deviating from the mean. “DAA is a case of the CIO and his team changing the SAA on a more regular basis to reflect the short-term outlook for the markets,” says Tony Lally, chief executive officer at Sunsuper. “The concern we have about that is we really don’t think it’s appropriate because markets don’t always move in a rational way and you can get it very wrong.”
Lally understands the logic behind DAA, but like HOSTPLUS, says Sunsuper prefers to take smaller bets such as a view on the Australian dollar. “SAA is really based on long-term expectations and at any point in time you probably have more information about the immediate future than the long term and that’s why some people justify DAA,” he says. “However markets can stay irrational for very long periods of time, so trying to second guess the market by DAA at the macro fund level we think increases the risk in the portfolio.” To tilt or not to tilt? All of those offering medium-term asset allocation services emphasise that the SAA remains by far the most important decision for a super fund. The development of DAA represents an “evolution in thinking about the optimal ways of managing portfolios”, but is not the panacea that would have saved funds from the GFC, Russell’s Pease says.
“Trustees have to keep this in perspective and not think of it as a magic bullet,” he says. “The last 18 months have been traumatic for funds; member balances have declined in a way many thought unimaginable. There’s been a lot of interest because of what’s happened, but funds must remember that the absolute majority of returns come from strategic allocations. There’s clearly a hierarchy here; the strategic asset allocation comes first, and we believe there’s a strong case for additional return through active management. [Enhanced asset allocation (EAA)] is in addition to both of those.” Gareth Abley, head of asset consulting at MLC Implemented Consulting, says the debate over set-and-forget versus strategic tilting is “still a second order issue”. “Medium – term asset allocation matters – maybe a lot if the ranges are big – but it’s important people don’t lose sight of the fact that the factor that has the biggest impact on returns and risk is still the neutral strategic allocation,” he says. “The risk is that people will compete in the returns generated by these ‘stractical’ processes.
If you do that, you lose the purity of what you’re trying to do.” Rather than debate the merits of one strategy over another, Abley says the debate needs to move on to focus on the relative quality of the different processes. “It’s just like the old debate around active and passive management,” he says. “There are merits to both, but once you’ve decided you’re going active, the key is which provider is likely to do it better.” Indeed, processes vary widely depending on the foundation of the firm that’s offering the service. For example the version of DAA being pushed by most traditional asset consultants is vastly different to that being offered by funds managers in the space. Schroders uses a DAA approach for its Real Return Fund, which aims to deliver an investment return of 5 per cent per annum above Australian inflation over rolling three-year periods.
Unlike super funds, which take DAA tilts away from their SAA, Schroders is not operating in a benchmarkrelative space, so decisions are made according to how much absolute risk the manager wants to take in a given asset class. Doyle says the way DAA is being used by some consultants and super funds is not really that different to TAA, with a slightly more mediumterm tilt. “There is this idea that permeates the industry that equities go up and if you want decent returns then you need to have the bulk of the risk in your portfolios invested in equities,” he says. “Our view is that sometimes that makes sense but sometimes it doesn’t and DAA is about continually evaluating in effect the risk premium that’s available across asset classes and shifting the risk within the portfolio to reflect where that risk premium lies, in the context of our investment horizon.” In this sense, Schroders is attempting to build an objectives-based portfolio made up of assets that are best placed to meet that objective, rather than having a fixed allocation to equities and bonds and tinkering around the edges. Colonial First State Global Asset Management (CFSGAM) also adopts an objectives-based approach to investing for its institutional clients.
Joe Fernandes, head of the global investment solutions group at CFSGAM, says the firm does not believe in tactical asset allocation but rather has a “reward – for – risk philosophy” for its multi-asset portfolios. As a portfolio manager, he says the levers available within TAA among a small number of asset classes or sectors are limited relative to stock selection across a much broader universe of opportunities. “For our institutional investment solutions business, our starting point is to understand the investment objectives of our investors,” he says. “We build portfolios aligned to those objectives or to the investor’s liability profile. For those portfolios, the starting point isn’t the SAA at all, it’s the liability profile of the investor. We then look amongst all the sources of risk that are available for those that will contribute to the achievement of the investment objectives. The asset allocation decision is a derivative of the risk allocation decision.” He says the concept of DAA is intuitively appealing, particularly following the extreme market events of last year, but the challenge is in the execution. “It’s possible to be right in your investment view but for markets to move against you. Getting the timing right is a real challenge,” he says.
BTIM does not describe its allocation process as DAA, but uses a combination of valuation-based longterm asset class forecasts, with frequent reviews and tilts if necessary, and a TAA overlay through the Global Macro group which is designed to make money from high frequency trading. “You’ve got three things to worry about: one is the return, one is the volatility of the return, and the other is more esoteric – it’s the way in which asset prices tend to move together, or the covariance of the return,” Swift says. “We are happy to set a policy mix but let the exposures ‘drift’ with the market. This is a way to let the portfolio benefit from the tendency for asset class returns to show serial correlation – that is they can go on long upward or downward moves. “In setting any policy mix you need to acknowledge that you’re going to be wrong. Be humble in your forecast, there’s a very good chance that you’ll be wrong in one if not all of those three key variables. When you add the complexity of the risk taken by the investment process within the asset class you have lots that can go wrong.
Don’t let the DAA, TAA or SAA dominate the overall risk budget.” One of the fundamental principles behind Russell’s EAA discipline is “first, do no harm”, Pease says, adding that Russell would prefer to “miss out” than go into a position that proves damaging to the portfolio returns. A historical opponent of TAA, Pease says there are fundamental differences between TAA and EAA. “It differs to TAA in that our preference is to do nothing,” Pease says. Inherently, TAA is an alpha process, not a risk management process, adds Greg Liddell, head of investment consulting at Russell.
“Russell is very strong on risk budgeting, and for a given risk budget we believe there are better places to spend that,” he says. Whatever the process, governance is recognised as a critical element of a successful DAA program. Funds must have clear governance structures in place to be able to implement DAA in an appropriate manner and Liddell says any DAA decision should receive board level approval. “If you tilt away from the SAA it’s appropriate that there’s a person within the super fund that has the technical ability [to implement the tilt] and can do so in a timely fashion,” he says.
They must also have an exit strategy in place when taking a DAA tilt, to stop them from “falling in love” with the position, Pease adds. But governance is important not only in the ability to make and implement decisions efficiently, but in the ability to bear some peer-relative risk in the short term, according to Watson Wyatt’s Chee. “At the base level we think a robust and well informed analytical framework is the key starting point,” he says. “You need judgement and experience of working in investment markets, cognisance of what happens in different market environments to be able to work out how much weight to give to the different indicators you’re getting in. “Clearly opportunities can come and go very quickly and similarly opportunities can come and generate value over a three to five year horizon, but you may suffer a bit of pain before you get there. “[You need to] maintain conviction in the positions you put in place initially and the framework that led to those decisions and your belief that you will generate excess return over the timeframe you specified.”