Several of the world’s largest sovereign wealth funds already have announced reviews of their long-term ‘buy and hold’ strategies with an idea to reducing fixed weights to stocks
The market crashes have been too extreme, and the disappointments too profound for investors simply to carry on as before. Several of the world’s largest sovereign wealth funds already have announced reviews of their long-term ‘buy and hold’ strategies with an idea to reducing fixed weights to stocks. They are revising their ‘alternative baskets’ of hedge fund and private equity investments to free that capital from lock-ups. A major state pension fund has handed billions of dollars to multiple managers with instructions essentially to invest the money in any major asset class, anywhere in the world at any time.
Tactical asset allocation means using market-timing to sell risky assets in order to protect capital, and to buy back when the time comes to capture returns. This technique began to attract serious interest when the global equity bull market slid into its first crash in 2000, but until 2007 played second fiddle to the fund-of-funds promise that combinations of alternative strategies would deliver diversified returns no matter which direction markets went. When last year’s share collapse melted hedge funds and private equity, along with nearly everything else, tactical asset allocation came to the fore as a mainstream approach to investment. Why? Simply put, those who did it successfully went through the worst financial markets since the great depression with their capital intact.
Different styles of asset allocation
If for the second time in a decade, market-timing techniques helped some investors avoid losing half their money, what are they exactly, and how will they be used in wealth management going forward? After all, the term could as well be used to describe macro funds, which chase returns here and there across the world, as to describe minor adjustments to the central weightings of stocks, bonds, cash, real assets and alternatives in a portfolio. The middle of the spectrum might be an investment process designed to deliver the long-term returns from investing globally, but to control risk by changing the asset mix in a very dynamic way when needed.
One innovation has been to allow managers full freedom to set asset class weights, but to give overall guidelines as to how much total risk the portfolio may have. Because the risk in your portfolio comes from the volatility of the assets it holds and by how much those assets move together, a simple notion follows: managers can slide your portfolio down the risk scale by selling high-volatility assets for low-volatility assets. In place of the S&P 500, the Nikkei 225, emerging markets, metals, mines, commercial real estate, high-yield, mortgage-backed and convertible bonds, managers can hold deposits, low-volatility funds and government loans. Portfolio risk moves right down the scale. When it is time to participate in rising markets, less volatile holdings are dropped for asset classes with higher risk and higher expected returns. Portfolio risk slides back up. The effort is spent in deciding which markets to hold, and in making sure all positions are large and liquid enough to be changed whenever necessary.
Understanding the process
For global wealth management, holding a base-case allocation, fixed weights for every market to provide the best trade-off between risk and return, is a tried and true technique. Sliding the portfolio away from that base-case allocation, moving it down the risk scale to avoid bad markets, then up the risk scale to get in front of rising markets, is a major enhancement. Here are some examples of what can go into a tactical asset allocation process.
Electronic databases give a flood of prices, financial results and economic outcomes that track the global business cycle while the markets absorb and discount the latest data reports. Analytical tools to help predict recessions and recoveries are widespread; every central bank uses them and money managers tend to have versions that focus on spotting near-term economic surprises, or forecasting major inflection points for growth that will trigger significant changes in market trends.
In addition, members of the investment community always keep central bankers under a watchful eye. This is because markets go to their most abysmal levels when central banks have lost control of general prices, destroying savings through hyperinflations or bankrupting borrowers in deflations. When Chairman Bernanke declares that credit, unemployment and housing will affect US interest rates, enterprising managers will model precisely those things so as to know when a policy change may be afoot.
The spread of specialist funds worldwide, run by investment managers who are undoubted experts in their fields and tasked with buying and selling their particular asset classes, has provided wealth managers with new sources of market information. Through the specialists, wealth managers get warnings of dislocations in one asset class not yet reflected in the others, can measure leverage in the system and see which trades are crowded and perhaps dangerous.
Valuation measures come in a broad spectrum, with many competing claims, yet are far too important to brush aside. Although markets bubble and burst, making valuations appear flexible, prone to misinterpretation and as slippery as perceptions, the metrics are essential to risk control. Stretched valuations give a clear notion of how far a market is likely to fall, once it starts to go.
Price patterns are the key to many short-term strategies. Tactical asset allocation often uses so-called technical analysis to confirm long-term trends, or to see where asset prices could go before reaching long-term support or resistance levels.
The investment process is paramount
Working with tools such as these gives Iveagh’s wealth managers a disciplined methodology for predicting bad markets, and recognising conditions that will change for the better. They can hold the large, liquid securities available today for exposure to almost all asset classes, including alternatives. Dynamic asset allocation, making portfolios flexible in changing market conditions, is one of the practical, mainstream answers to how wealth management portfolios should be run.
Cambiz Alikhani, John Ricciardi and Christopher Wyllie, partners at Iveagh Private Investment House
