Tactical asset allocation can make a considerable difference to portfolios

Andrew Dittberner, Senior Investment Manager at Cannon Asset Managers and portfolio manager of the Cannon Flexible Fund talks about the SA’s exciting new tactical asset allocator unit trust which aims to provide investors with capital growth over time by investing in two asset classes, namely equities and cash.

One of the most important skills in managing funds is asset allocation, yet it is one of the hardest aspects to master. Worse, a bad asset allocation decision can even lead to destruction of capital. A quick glance at some headlines of ASISA press releases reveals that unit trust investors regularly fail to add value through asset allocation:

- “Investors fail to time the markets, again!” (3 February 2010)

- “Nervous investors lose out as market timing fails” (5 May 2010)

- “Investors continue to avoid equities, but pour billions into fixed interest” (2 February 2011). Unfortunately equity funds were the better performers during the December 2010 quarter.

We can see from the following graph that over the long term, equities (ALSI) outperform bonds (ALBI) and cash (STeFi).

Figure 1: Equities Outperform in the Long Run (1980–2010)

Over the period 1980 to present, the ALSI has returned 10.5% per annum. However, there are years where equities heavily underperform their lower beta counterparts, bonds and cash. If, with perfect hindsight, one were able to reduce equity exposure to zero in years where equities underperformed cash, and hold cash instead, the portfolio’s average annual return would have increased to a staggering 26.8% per annum, as shown in Figure 2.

Figure 2: Perfect Tactical Asset Allocation

Cannon Asset Managers finds a solution

Cannon Asset Managers has developed a market valuation tool that considers the earnings of both the market and the underlying companies over a seven-year period, a Cyclically Adjusted Price Earnings (CAPE) Ratio and applies this tool in South Africa. Earnings are cyclical, and by considering longer term trends one is able to get a good sense of “normalised” or “sustainable” earnings of the market as opposed to near-term earnings that are impacted by short-term economic cycles. By applying this normalised earnings number and the current price, Cannon Asset Managers create a CAPE ratio that is far more effective in indicating the relative value of the market. This avoids decision-making based on sentiment and recent market experience, which often can be misleading.

The conventional PE ratio is highly sensitive to the state of the business cycle. On the other hand, the CAPE ratio inflates five to ten years’ worth of earnings to today’s prices and averages these earnings out over periods that, in all likelihood, span a business cycle. Therefore, by using long-term “normalised” earnings, the CAPE ratio places a greater emphasis on price movement as opposed to changes in earnings. This result is important because, through investment and business cycles, earnings tend to be stable whilst price is far more volatile. In the case of buying any asset, price is what you pay while earnings are what you get.

For example, in 2007, all earnings were buoyant, and when measured against the equity market’s price, which was also high, a “fair” reading of 15 times earnings was given. By applying the CAPE ratio to that market, clear guidance would have been given to suggest that equities were extremely expensive, in excess of 25 times “normalized” earnings.

How is the Cannon Flexible Fund managed?

The Cannon Flexible Fund is built using the above rules that guide when to hold cash, and when to hold equities. Depending on the domestic equity market CAPE valuation, tactical shifts in the exposure to the asset classes will be made between 100% deep value equities and 100% cash, and the portfolio will move in increments of 25% between these parameters.

The long-term strategic asset allocation of the portfolio is 50% equities, and 50% cash and the benchmark is thus 50% FTSE-JSE ALSI J203T (equities) and 50% STeFI indices (cash). However, the fund will not comply with Regulation 28 of the Pension Funds Act, as at times, the fund will hold up to 100% of its assets in equities.

The fund makes no use of derivatives to either hedge or change the allocation to equities. The portfolio is managed according to Cannon Asset Managers’ well-established and successful deep value investment philosophy, selecting shares that meet all of the criteria in their house view equity portfolio.

Performance has been excellent

The Cannon Flexible Fund mirrors the “Allocator” portfolio, an institutional portfolio offering which has been managed since September 2009. Over this time, the Allocator portfolio has generated a return of 23.3%, which compares with the benchmark performance of 20.2%. The asset allocation moves in 25% increments and has varied from being fully invested in equities at inception, to 75% invested in shares, back to fully invested and is equally invested in cash and equities at present. The portfolio has almost kept pace with the equity market, despite the market’s strong showing over this period. This is testament to the strong tactical asset allocation toolkit that Cannon Asset Managers has developed.

In summary

Over the long term equities outperform all other asset classes. However, in the short term, equities are highly volatile. Therefore, through aggressively allocating exposure between high and low beta asset classes, tactical asset allocation has the potential to significantly enhance investment returns. Equally, getting these decisions wrong can be highly damaging to investment results. The Cannon Flexible Fund is designed to overcome the obstacles to effective tactical asset allocation through removing emotion from decision making, having the ability to reliably determine market valuations and knowing that history carries with it significant information about the future.