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The latest thinking in asset allocation

18 October 2011 Gareth Stokes
Gareth Stokes, FAnews Online Editor

Gareth Stokes, FAnews Online Editor

Asset allocation is one of the main drivers of long-term investment return. Poor asset allocation can lead to permanent capital destruction, so it is imperative that your investment portfolio is spread sensibly across cash, bonds, equities and listed prop

Andrew Dittberner, Senior Investment Manager of Cannon Asset Managers has some ideas on how to improve asset allocation results. The first step is a thorough understanding of the existing setup. Most asset allocation strategies rely heavily on forecasting events and macroeconomic factors (such as corporate earnings, interest rates and inflation) which are inherently difficult to predict. “A more sensible approach to asset allocation is valuation based – trying to work out if current asset prices are expensive or attractive,” says Dittberner. “The pitfall here is how you conduct your valuation and which aspects of the asset you value.”

Can CAPE replace the crystal ball?

One solution is to use a unique market valuation tool that incorporates the seven-year earnings of both the market and its underlying companies. Cannon Asset Managers has labelled this “tool” the cyclically-adjusted price earnings (CAPE) ratio! How does it work? According to Dittberner the CAPE ratio removes the “noise” or excessive volatility associated with one-year earnings figures, and gives the asset manager a better sense of the “through the cycle” capability of the market or company in question. Looking at earnings performance over a longer period strips out the aberrations which occur over the short-term – in much the same way, analysts warn against judging a unit trust on its one-year performance. More often than not, this year’s “high flyer” is next years’ “also ran”.

Using the CAPE metric Cannon Asset Managers is better positioned to judge the attractiveness of a company (or market) they are keen to invest in. “By removing both emotion and forecasting from the decision-making process, we are able to substantially improve tactical asset allocation decision,” he explains. The group is already applying this investment methodology in the Cannon Flexible Fund, despite it only comprising two asset classes – equities and cash. Another innovation in this fund is the interesting manner in which the “split” between equities and cash is structured. The exposure to asset classes varies from 100% in “deep value” equities to 100% in cash, in increments of 25%. In other words, the portfolio will hold 100%, 75%, 50%, 25% or 0% in equities with the balance in cash. As already mentioned, the asset allocation is informed by prevailing market CAPE ratios.

A strategy that works...

Asset managers love testing their share selection strategies against historic data. In keeping with tradition Cannon Asset Managers back-tested the CAPE ratio by considering the median and the average one-year real returns from the FTSE-JSE All Share index over 25 years between 1986 and 2011… In each of the 12-month periods where the CAPE ratio advocated allocating 100% of available assets to cash, both median and real returns were negative! This suggests the model could accurately warn of negative equity market returns, allowing investors to exit the index during truly bleak years, such as 2008. At the other extreme, when the model pointed to a 100% equity weighting, the following year’s average and median real returns were in excess of 20%. By applying the simple rules of the CAPE ratio framework, the asset manager expects to significantly enhance portfolio returns.

The CAPE ratio framework was successfully back-tested on a second data set of positive versus negative real returns on the JSE All Share index, also covering 25 years. When equities are expensive – causing the CAPE ratio to recommend 0% equity exposure – there was a better than even chance of achieving a negative real return from equities over the following year. When the model signalled a 100% equity allocation, there was a greater than 80% chance of a positive real return from that asset class.

A successful asset allocation strategy requires higher  weightings in outperforming asset classes, year in and year out. Although Cannon has simplified the task by only considering cash and equities their model seems to work. They illustrate the power of their tactical asset allocation strategies by proving its ability to avoid the equity market (and poor returns) when shares are overpriced – and raise exposure to equities when the market is undervalued! The real winner is the investor, who will benefit from the greater upside potential. The results are not yet in on the CAPE ratio method… The Cannon Flexible Fund was only launched on 1 April 2011 and we’ll have to wait some time before its historic “success” translates in the real world.

Editor’s thoughts: Everything in economics is about cycle. Page through your economics 101 text and you’ll soon discover the lead and lag between business and markets… And because we know business cycles play out over periods of seven years or longer, it makes sense to apply similar cycles to investment forecasting. Are you happy to place your client’s capital in an asset allocation fund that allocates to cash and equities only? Please add your comment below, or send it to

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