Before addressing the particular merits of dynamic asset allocation it is worthwhile examining the attributes of its notional alternative: static asset allocation.
Termed in this manner, we might not immediately recognise static asset allocation. To a marketer’s attuned ears, it lacks intuitive appeal: stasis being less comment worthy than dynamism. Dynamism, after all, is an appealing personal attribute. Being called static is not often a compliment. It suggests a degree of unresponsiveness and lack of sensitivity to environment.
The practical application of what we have mischievously called static asset allocation is most commonly found in balanced strategies and mandates. A little bell of recognition is now heard. Balance has much greater intuitive appeal and practical application.
The balanced mandate, an exemplar being a constantly held mix of equities and bonds (say, 60/40 in relative proportions), owes its existence to the following four phenomenon:
– equity and debt are the two key, entirely dominant, asset classes of finance,
-by holding a proportion of bonds, the investor offsets the perceived high volatility of the equity return stream,
-the fixed nature of the allocation removes the risk of poor timing decisions &
-the mixed nature of the allocation somewhat reduces the effects of periods of bad performance in either part of the allocation.
Of course, the balanced approach is not immune to losses. It does not, in any way, address the effects from periods when both equity and debt perform poorly.
However, the experience of the 20th century, from which almost all our notions of financial return derive, reveals that, in the US, there was only one month since 1925 (September 1974) over which a 7 year rolling return was negative. The remarkably positive experiences of twentieth century investors explains the popularity and underwrites the endurance of the balanced (or, static) strategy.
The chart below describes this long period in the sun:
7 Year Annualised Rolling Returns 1926-2013 (US)
Source: Morningstar/ Cerno Capital
The question we should ask is whether the philosophical underpinnings of the static approach, or its dynamic alternative, holds greater appeal for the century we live in notwithstanding what transpired in the last?
Part of the answer to this lies in an imagination of future long term asset class performance and the factors that will shape it.
The product of our own meditation on these matters is the ineluctable conclusion that the debt mountain that has been built up in the second half of the 20th century is likely to cause great problems within financial assets in the first half of the 21st.
The 2008 crisis had at its cause indebtedness and the misunderstanding, mismarketing and mishandling of debts. The solution has been extraordinary dollops of liquidity, liquidity that is now in retreat. We are deeply concerned that many businesses and the consumer sector, at large, have become accustomed to super low interest rates and will have trouble weathering more normal interest rates. This suggests to us the beckoning of a period when both the equity and debt asset classes may struggle to record positive returns.
If this indeed transpires, this cratering of returns will pose great challenges for balanced managers on account of the flexibility that they have denied themselves. It will also place a substantial log in the path of the onward marching passive industry. For whilst ETF providers like to trumpet periodic innovations such as smart beta and putative ability to track alternative indices, their assets are substantially gathered in long only, headline index tracking strategies.
The appeal of passive investment rises as bull markets extend. For, during these times, index returns and reduced fee drag appear to be just the ticket. It is our belief that this appeal will tarnish if the next bear market envelops both bonds and stocks, as we believe it might. To have “gone passive” will cease to be quite the boast it is today for trustees of charities and educational endowments.
The merits of active or dynamic allocation are to be found first in both the flexibility to have sharply different allocations to debt, equity and cash over time and secondly in the ability to seek out and utilise other asset classes or sub classes of the main classes.
On the first point, it is hard to be doctrinaire as to the optimal approach: the allocation cat can be skinned in a number of ways. At Cerno Capital we use a three year forward return framework to guide our allocations. Three years allows us to frame our thoughts outside the very crowded near-term, long enough for valuation disparities and extremes to possibly mean revert but not so long that our clients find themselves disadvantaged by logically sound but practically profitless investment positions.
Flexibility also allows participation in specific asset classes whose attractions only manifest when the stars periodically align. For example, the corporate credit sector offered, in 2009, a once in a generation set of possibilities: deeply discounted paper with marvelously fat yields to maturity, secured against still robust cash flows. In the four years since 2009, valuations have travelled full circle to a point where future returns are likely to correlate very strongly with normalising government curves. The opportunity has been fully mined. It does not, therefore, make sense to retain a permanent allocation to corporate credit or its higher yield cousin.
Presently we see a developing opportunity in merger arbitrage strategies. Specialist merger arbitrage and event driven managers make money by investing in and around announced acquisitions, mergers and other corporate activity. We anticipate activity will rise as companies become more expansionary into an improving global economic environment. However, merger arbitrage is not plausibly an evergreen investment for the flexible multi-asset class investor. There can be long drought periods: for example, capital committed in Europe over the past five years sat idle.
In the field of global macro, no two managers invest in an identical fashion, however certain firms have a greater concentration in strategies grouped around policy rates (the official rate of borrow that central bankers control). During a period when most key central bankers are operating what they term “forward guidance” which entails anchoring policy rates at their current levels for the foreseeable future, the managers with the highest dependence on short term rates trading are working within the most reduced opportunity set: another reason for flexible allocation.
Within mainstream equity strategies, we see plenty of reason to challenge the orthodoxy that emerging markets are intrinsically better places to invest than developed markets. We are fully cognisant of the long term trend for small capitalisation issues to outperform larger cap shares, however we would not invest in a static manner unless valuations were reasonable.
There are certain asset classes that lack a core attribute for long term investment but may prove to be excellent investments in certain periods. Good examples are found in gold and commodities, both of which lack income attributes.
We periodically deploy currency overlay strategies when we wish to hedge out foreign exchange risk: another example of necessary flexibility, to our minds.
Finally, when we read through our own choices to the strategies of the managers we might select as allocators, we are drawn to those that themselves secure adequate flexibility.
Our adherence to the credo and practices of active asset management are anchored on two beliefs: firstly, that a minority of investment teams and processes can secure meaningful outperformance against indexes and secondly that we reject the inbuilt biases that investors have carried forth from the twentieth century. As the warming comfort blanket of central bank support is gradually peeled away from our beds, we are likely to find additional evidence of the fundamental instability of global capital markets and global money flows throughout these markets. This, we contend, is a time to be flexible and not to buckle into strictures whose rationale is based almost entirely on past performance of a time past.
Extracts of this article appeared in the Charity Times, February-March 2014