Category Investments

Asset Allocation – An important contributor to portfolio returns

01 December 2021 Luigi Marinus, Portfolio Manager at PPS Investments

As a multi-manager, the two most important investment decisions we face are manager selection and asset allocation. Our manager selection process is aimed at identifying managers and funds that deliver consistent long-term performance aligned with the investment philosophy of the strategy.

The process entails screening, due diligence (that includes quantitative and qualitative analysis) and a manager blending exercise that identifies which strategies combine well to deliver a diversified outcome for clients.

Asset allocation as an investment strategy is based on the empirical studies focused on how each asset class performs and correlates relative to each other. It is the large lever impacting both risk and returns delivered by any portfolio.

Let’s unpack the asset allocation process, using the most recent house view change, as an example of how this is applied in practice.

Optimising the long-term asset allocation

The asset allocation process starts by optimising a long-term strategic asset allocation (SAA). This SAA uses the historic returns and volatility of the various local and international asset classes to assign allocations based on the ability to achieve an inflation target over time. The higher the inflation target, the more risk the allocation assumes, which generally implies that more equity is required, but historic volatility is considered to ensure unnecessary risk is not onboarded. The SAA is modelled annually to keep it up to date, but seldom changes due to the long-term nature of the inputs.

Taking advantage of short-term opportunities

The shorter-term component of the process is the tactical asset allocation (TAA). Here an 18- to 24-month view is applied to tactically adjust the SAA based on three prevailing factors surrounding the asset class: the valuation, the macroeconomic aspects that are currently affecting it and the price momentum. While each of these factors are considered for each asset class, there is an additional relative assessment that compares asset classes to each other as well. The TAA decision results in a maximum underweight, underweight, neutral, overweight or maximum overweight allocation to each asset class. These allocations are relative to the SAA, with the midpoint of the neutral band for each asset class equivalent to the SAA level. The range from maximum underweight to maximum overweight is predetermined per inflation level to guide the asset class allowance when a change to the TAA is made. It also ensures that tactical shifts are not too profound that it significantly alters the risk-return signature of a fund. The TAA that the investment team implements is the PPS Investments house view and applies across all PPS funds.

In the house view meeting held in July, it was decided to make changes to allocations to SA equities, global equities and SA property. Figure 1 below shows the current house view for each factor and the asset class changes highlighted.

Figure 1 – Latest tactical asset allocation

Changes implemented were in global equities from maximum overweight to overweight, SA equities from neutral to overweight and in SA property from maximum underweight to underweight.

The change in global equities was as a result of the valuation factors reducing, due to the high valuations of large global stocks, particularly those that benefitted from the global lockdown conditions. It is important to note that even though the allocation to global equities has reduced the strong macroeconomic factors of low global interest rates, improving US GDP and the continued price momentum meant that an overweight compared to the SAA was still applied.

For SA equities, valuations improved as greater certainty around the earnings prospects of SA companies emerged and the vaccine roll-out gained momentum across the country, improving the possibility of a reduction in lockdown levels. Even though all three factors were positive, a maximum overweight position was not implemented as more evidence of these improvements need to be observed before a further strengthening of the allocation will be considered.

The third change to the TAA saw an improvement to the valuation of SA Property. Although this improved, the macroeconomic conditions for SA Property remains the primary concern due to the uncertainty of the asset class as SA emerges from its lockdown status. Although the allocation to SA property has increased, the TAA remains underweight in the asset class relative to the SAA.

As with all asset management disciplines, implementing a repeatable consistent process makes long-term goals achievable. At PPS Investments, we ensure that our asset allocation process is implemented and constantly monitored to ensure the most recent and relevant information is considered. Markets may not behave exactly as investors would like in the short term but having an experienced investment team implementing a consistent process can give some peace of mind.

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