Dynamic Asset Allocation I
Over the years I have seen many strategies developed by financial institutions for conservative investors, but it can be difficult for wealth managers to keep a 20 year time horizon in mind when there are annual targets to be met. This 'core fund - 20 year view' is rarely seen outside Family Offices and Pension Funds and perhaps the most authoritative view I have come across emerged from meeting with a Family Office team I came across just after the global financial crisis of 2008.
At a time when most families were 'crashing through an enormous storm' the Family's wealth was enjoying a 'gentle cruise on a becalmed Lake Zurich in Switzerland'.
I have visited the team on many occasions in Switzerland over the last 10 years as I have sought to understand in detail the considerable intellect that has been applied to creating this model and I guess I am still just scratching the surface.
In 2011 they opened up their dynamic global strategy to other families in order to share their ideas with the outside world..
Investing dynamically in uncertain times
The objective of a dynamic investment process is to achieve higher long-term risk adjusted returns than static strategies, such as buy-and-hold. Compared to buy-and-hold strategies, a dynamic investment process executed properly can produce higher, smoother returns at any level of risk. A dynamic investment process incorporates both strategic (long-term) and tactical (short-term) steps.
The strategic part, the so-called Strategic Asset Allocation (SAA), consists of developing a "base" asset mix that supports the investor's goals over a specified time horizon. The composition of the mix is determined by the investor's time horizon, constraints and risk tolerance, as well as the long-term expected risks and returns of the various assets. As with any other long-term plan, as time goes by, the SAA needs to be revisited and adjusted when necessary in order to stay on target through a changing market and economic environment. These changes are made based on medium to long-term developments in the investment environment.
In contrast to SAA revisions mentioned above, Tactical Asset Allocation (TAA) involves making portfolio changes based on short-term market developments, including events or new information that is expected to have a significant but likely short-lived effect on markets. In these cases, the portfolio manager either adds to or cuts investment exposure to a particular market or sector in order to avoid losses on bad news, or to increase profits on good news.
There are two main requirements for the successful implementation of a dynamic asset allocation strategy: A reliable forecast of the future changes in market circumstances and a disciplined and consistent investment process.
Forecasting or anticipating market changes comes in different guises and qualities and ranges from the complex but more reliable method using formal statistical procedures employing time series and cross-sectional data, to simpler but less reliable methods using judgmental and naive techniques which often rely on a limited number of “rules-of-thumb.” Clearly, the accuracy of market forecasts is crucial to the investment outcome, and is improved greatly by a careful, systematic process as opposed to an undisciplined “gut feeling” approach.
The principle of an adaptive and dynamic asset allocation, in the framework of a Strategic Asset Allocation and a Tactical Asset Allocation, is widely accepted. The vast majority of banks and asset managers apply the concept to varying degrees in their recommendations and investment decisions. However, only a small number of market participants attempt to extract to the fullest the potential value of a dynamic investment strategy, by engaging consciously and consequently in it.
The importance of the investment process – the method by which investment goals are translated into an investment portfolio – is often underestimated in terms of its impact on the ability of the resulting portfolio to deliver.
Without a clear structure and a consistent execution, portfolio management that began with the intention to meet an investor’s goals can deteriorate into an exercise in damage control.
The benefits of a systematic dynamic investment strategy to an investor’s portfolio are large and numerous. Developing reliable market forecasts through a carefully conceived and consistent method, and using them to apply appropriate portfolio changes systematically, greatly increases the chances of escaping major market losses while participating more often in market gains. Additionally, the process can be applied to any level of risk the investor desires. At any desired risk level, a systematic dynamic investment strategy can result in increased returns over a static portfolio management process, without increased risk.
The manager looks at 3 different angles of risk: FX, Credit side and Equity side. Most post-war crises originated from this and got early warning signs in any of these fields. At the start of the strategy, the tail-end of the internet bubble, we stayed out of equity due to elevated volatility and economic distress. The credit crisis gave us early warning signals that made us reduce equity positions in late 2007, avoiding most of the downturn and losing only around 6% in 2008. In 2011, we got completely out of equity in April, to replace it with long term government debt and increasing the duration in the months after. In any given month of 2011 we made money and closed the year around 10% up. Looking at 2002, 2008 and 2011 the cumulative loss investors would have would be -58% in equity (MSCI World). Our clients lost accumulated only -3.6%, resulting in a recuperation of respectively of 137% versus only 3.8%. This gives the state of mind of having to take less risk to recuperate, not mentioning the sleepless nights. Avoiding losses results in better returns without the need to remain invested in risky assets.
We look at all potential risks, even those with a minor chance of occurring, if the impact on your wealth would be big.