Clarity and time – a winning combination

Adrian Clayton, managing director, joined Northstar Asset Management.

For the purpose of this article, the wider concept of asset allocation should be dissected into its two underlying sub-components, namely strategic and tactical asset allocation.

Asset allocating is assumed to be a practice that requires predicting future outcomes. Strategic asset allocation relies on historical data with the underlying premise that ‘history repeats itself’ and there is no predictive component. Tactical asset allocation, on the other hand, uses methods to assess future outcomes. In this article, both disciplines are discussed.

Before delving into asset allocation concepts, Northstar Asset Management demonstrates the importance of ‘time’ and ‘patience’ when making any investment decision. The graph below shows prospective returns that are generated off different price/earnings (P/E) levels on the JSE.

It is clear that the higher the P/E, the lower the future returns. In fact, buying the market on higher P/Es increases the chance for negative future returns. Investment managers using such information to de-risk their portfolios on the JSE in 2014, would have been left stranded as the market soared ahead and, interestingly, the highest P/E sectors on the SA market gave the greatest returns in 2014. Although this is counterintuitive and inconsistent with conventional wisdom, it has happened many times in the past. Expensive markets can rise further, far exceeding expectations – stock market behaviour is, in the short term, random. Thus, the difference between being ‘right’ and ‘wrong’ is not about data interpretation (expensive markets always revert to normality), but rather, the time horizon.

FTSE/JSE ALSI one year returns since January 2005

Source: I-Net Bridge

There is a strong argument to be made that investor interests are not being well served in the local savings market due to overlapping roles between financial advisers and investment managers. Northstar believes strategic asset allocation is closely aligned with the planning process – a task that rests comfortably with financial advisers. Strategic asset allocation can be defined as the process of allocating capital to cash, bonds, real estate and equities in such a manner as to optimise risk and return to achieve the financial goals of the investor over the long term. Good investment managers use these tools internally for portfolio construction and Northstar believes that closer working relationships between financial planners and investment managers should be fostered, to ensure advisers have access to modeling so they can enhance planning.

Tactical asset allocation, on the other hand, should be aligned with the investing process and this is the domain of investment managers. This is a complex and expensive function and good investment managers require the following to ensure competency in this area:

• Timely, accurate asset mix information and robust systems
• A team with the right skills to identify attractive asset allocation opportunities
• A systematic process based on formal return-risk forecasting that can be tested
• Timely feedback through accurate return attribution

Tactical allocation has a shorter-term time horizon and involves adjusting asset class weighting away from passive levels (strategic levels) to reflect the investment manager’s current view on which investments have the best risk-return payoff profiles in the near term.

The two primary methods of assessing the ‘correct’ tactical asset allocation are macroeconomic forecasting and quantitative analysis. Quantitative analysis is centered on calculating expected returns based on scenario analysis using inputs such as interest rates, oil prices and currency levels. A strong scenario framework uses historic price activity together with current asset class valuations to assess what possible future returns might be likely.

Northstar is an investment management firm that is skeptical of heavily relying on macroeconomic forecasting, as the company believes there is little evidence to show high levels of predictability in this field. The company’s experience leads it to believe that the best method of tilting a portfolio is directly linked to bottom-up instrument analysis, which stems from detailed research together with scenario analysis. Northstar also believes aggressive tactical switches, which are better described as active trading, are value-destructive and it is far better to allow enough time to pass for outcomes to be realised. Rational scenario analysis, given enough time, improves predictability – the enemy of this approach is a short time horizon.

In conclusion, the following has been argued:

• The planning process could be enhanced if advisers use optimisation tools for strategic asset allocation
• It is Northstar’s contention that tactical asset allocation should be the domain of investment managers, with the teams and systems to do so
• The correct approach to tactical asset allocation is scenario analysis with limited macroeconomic forecasting
• Astute clients and advisers give competent investment managers enough time for their calls to unfold as markets are ‘random walks’ in the short term