By Yoram Lustig
An investor’s asset allocation has typically comprised a long-term, systematic process (Strategic Asset Allocation) adjusted for short-term market views and conditions (Tactical Asset Allocation). These approaches, sitting at opposite ends of the investment horizon, leave a gap for investors to bridge for optimising the allocation over one to five years by developing a Medium-Term Asset Allocation (MTAA) process.
The SAA and TAA approaches have contrasting strengths and shortcomings. SAA can quantify expected risk / return and use this to optimise the allocation; however, it is not dynamic. Meanwhile, the objective of TAA is to add excess return or mitigate risks by tweaking asset allocation, but the challenge is in quantifying the expected return and risk of assets and allocations over the short term.
MTAA can capture the strengths of both SAA and TAA processes, conferring the ability to consider current market conditions and to actively incorporate forward-looking market views. An MTAA process should analyse the market environment from all angles, and combine the four main groups of factors that are expected to impact asset prices: macroeconomic, valuation, sentiment and technical.
Macroeconomic and valuation factors mostly impact asset prices over the long term, as prices are expected to eventually converge to their fundamentals and fair values. Over the short term, asset prices are mainly affected by sentiment and technical factors. Sentiment can drive prices away from fair valuations, or if correctly identified, can present opportunities for investors to enhance returns or mitigate risks. Technical factors can be helpful in identifying entry and exit points and to complement or challenge the conclusions and output from the other factors.
Implementing an MTAA process can be done by first generating medium-term capital market assumptions that are ‘sustainable’, driven mainly by fundamentals instead of short-term noise. These will differ for each asset class, but in general should be based on forward-looking observable asset prices and market indicators, such as equity dividend yields and bond yields to maturity, and updated at least on a monthly basis. A consistent methodology across assets and time is necessary to provide an objective assessment of the relative attractiveness of assets.
The assumptions are used to generate active positions that deviate from the SAA to optimise allocation. Constraints may be introduced to avoid unwanted results or to limit the degree of active deviation from the long-term SAA benchmark.
Allocation can then be adjusted to reflect qualitative market views and expectations, based on macroeconomic and valuation factors, and to embrace the views of TAA to manage short-term risks and time trades. It is at this stage that investors can reflect their outlook on issues such as geopolitical risk and policy changes which are often based on judgmental analysis.
The active asset allocation should be reviewed to ensure that it is consistent with the investor’s objectives and constraints. Risk factor analysis can be conducted to ensure diversification not only across assets, but also across risk factors, and investors should assess the transaction cost impact of adjusting the asset allocation. This entire process should be repeated at least quarterly; in the interim the TAA process should ensure that the portfolio remains abreast of rapid developments across markets.
The value of MTAA is best explained using past examples. At the end of 1999 with negative expected returns in US equities, the process correctly identified the bubble in valuations just before it burst in March 2000. Similarly, in 2008 the spread between US high-yield bonds and US Treasuries surpassed 18% (Barclays Capital US Corporate High Yield Bond minus 10-year Treasury yield), a level never seen in ‘modern’ markets, and implied a default rate on a scale not seen since the Great Depression. According to the MTAA, the expected return on high-yield bonds was extremely attractive, in particular on a risk-adjusted basis relative to equities. Indeed, the spread dropped steadily as markets calmed down and the high yield market generated the highest returns since the inception of the high yield indices. The annual return in 2009 was over 60% (Bank of America Merrill Lynch Global High Yield Index) – something I would call a “once-in-a-lifetime” buying opportunity.
A MTAA process can bridge the gap between the long term, quantitative SAA and the short-term, qualitative TAA. By enabling investors to express their judgmental market views within a disciplined, risk-focused framework, ensuring that the allocation is in line with objectives, MTAA can add value over time.
Yoram Lustig is head of multi-asset investments UK, AXA Investment Managers
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