How to improve your asset allocation results

Andrew Dittberner, Senior Investment Manager of Cannon Asset Managers, finds a way to improve asset allocation.

It is well known that asset allocation is one of the most important, yet hardest to perfect, aspects of portfolio management. In addition, poor asset allocation can lead to permanent capital destruction. Most asset allocation fails as it relies heavily on forecasting things about the future which by definition are very difficult to forecast. A more sensible approach to asset allocation is valuation based – trying to work out if current asset prices are expensive or attractive. The pitfall here is how do you do your valuation, and for example, what aspect of the asset are you valuing.

Using a market valuation tool that incorporates the seven-year earnings of both the market and the underlying companies, a cyclically-adjusted price earnings (CAPE) ratio, Cannon Asset Managers has devised a tool to assist in improving asset allocation decisions. Using the CAPE ratio essentially removes the “noise” or excessive volatility associated with the one-year earnings figures, and gives one a better sense of the through the cycle capability of the market or a company. Thus, the CAPE metric gives a more accurate representation of the attractiveness of the market and companies alike.

“By removing both emotion and forecasting from the decision-making process, we are able to substantially improve tactical asset allocation decision,” explains Andrew Dittberner, portfolio manager of the Cannon Flexible Fund.

This fund is unique in that it consists of only two asset classes – equities and cash – and the exposure to the asset classes is made between 100 percent deep value equities and 100 percent cash, moving in increments of 25 percent. In other words, the portfolio will hold 100%, 75%, 50%, 25% or 0% in equities with the balance in cash. The asset allocation is informed by prevailing market CAPE ratios and results in a portfolio that is a true asset allocation fund.

The results are impressive. Figure 1 shows the median and the average one-year real returns from the FTSE-JSE All Share Index over the 25-year period 1986 to 2011, for each of the equity allocations. Essentially, when Cannon Asset Managers’ approach indicated that there should be a 0 percent weighting in equities, the subsequent 12-month average and median real returns were negative. At the other extreme, when the model pointed to a 100 percent equity weighting, the following year’s average and median real returns were in excess of 20 percent.

Figure 1: FTSE-JSE All Share Index 1-year real return (1986 to 2011)

In other words, by applying the simple rules of the CAPE ratio framework, Cannon Asset Managers is able to significantly enhance portfolio returns through tactical asset allocation.

Another way of looking at this is to explore the extent to which equities showed a negative or a positive return over one year, for each of the equity allocations. From figure 2 below, it can be seen that when equities are expensive and the allocation to equities in the model is 0 percent, there is a better than even chance of achieving a negative real return over the following year. By contrast, when they are attractive, as indicated by the CAPE ratio, and the allocation to equities is 100 percent, there is a greater than 80 percent chance the return over one year will be positive in real terms

Figure 2: FTSE-JSE all Share Index – positive vs. negative real returns (1986-2011)

These two charts demonstrate the power of the approach to assist with tactical asset allocation. By avoiding the equity market when it is overpriced, the poor returns which are subsequently delivered can be avoided. Conversely, by raising exposure to equities when the market is undervalued, an investor can benefit from the greater upside potential.

The Cannon Flexible Fund is constructed by applying the above framework that guides when to hold cash, and when to hold equities, while removing all emotion from the decision. Significantly, and perhaps the most distinguishing feature of the portfolio, is the high conviction in the tactical asset allocation decision, which allows the portfolio to move from a 100 percent equity position to a 100 percent cash position.