Combining strategic asset allocation with active management and exploiting tactical allocation opportunities provides the greatest potential for maximising investment efficiency in multi-manager portfolios - for example, risk adjusted returns
What is the value of active management?
Improving investment efficiency - maximising risk-adjusted returns - has found a new resonance in today's challenging market, as low real yields and reduced expectations for long-term equity returns have become a reality. More than ever, investors must generate returns higher than standard asset classes to meet their investment objectives.
How best to achieve this is the subject of much debate. Some investors believe markets are only inefficient at the individual stock level, but are efficient at regional or asset class level, leaving little room for adding value. The supporters of this line of thought, therefore, only attempt active allocations on a stock basis, for instance stockpicking - neglecting opportunities to manage risk or increase performance through Tactical Asset Allocation (TAA). We find this belief hard to justify.
We believe strongly that TAA has a vital role to play in improving risk-adjusted returns; that inefficiencies exist within and between markets; that these inefficiencies will persist in the future; that they are identifiable; and can be acted on. Our investment management process - Insight Alpha2 - aims to translate this belief into deliverables.
Empirical studies
In their often quoted 1990 study, Brinson, Hood and Beebower found that 90% of a fund's performance could be attributed to its asset allocation policy. This is often used to support the merits of TAA, but in fact this is a common misunderstanding: its conclusions actually address the variability of returns over time as a function of a fund's Strategic Asset Allocation (SAA) (eg its choice of benchmark). It concluded that since the SAA determined 90% of the variability of a fund's return over time, there was little opportunity to add value through active management and does not support TAA being a driver of returns.
In isolation, therefore, this study does little to support our argument. However, a later study (Ibbotson and Kaplan) addressed the effect of active management and found that active management accounted for almost 60% of the difference in returns between funds with the same SAA.
The combined conclusion of the studies shows that Strategic Asset Allocation and active management are of vital importance in determining the overall level of returns and successful active management can substantially add significant value versus other funds with the same SAA.
the role of tactical asset allocation
Imperfect information, sentiment, differing macro and micro analysis and investor confidence create opportunities at a stock level. However, if one believes that one stock can be identified with out-performance potential over another, it is hard to dispute that regions, investment styles or market capitalisation segments may also be used to identify out-performance potential.
Inefficiencies between markets do exist. Macro inefficiencies result from segmentation in the global investment universe. Many managers are constrained to a single region, and many investors do not think across asset categories or on a global scale. This contributes to the mis-pricing of regions and asset classes - there is not enough arbitrage to push prices to the equilibrium value quickly.
Within regions, one area becomes favoured by investors and receives the bulk of new capital, resulting in relative differentials in valuations within a region. A good example of this is the technology bubble of the late 90s, where the bulk of US equity inflows went into aggressive growth managers. This led to excessive pricing of this segment and more attractive relative values in traditional, out of favour 'value' sectors. Even within sectors, allocating across styles can significantly improve performance or reduce risk.
Each region is simply a pool of individual stocks, and if there is a skew towards attractive or unattractive stocks within a pool, then an investor can gain advantage by tilting the portfolio in favour of the more attractive asset class, region or style (see table).
This tilt is called a tactical asset allocation. A TAA provides the opportunity for short-term profit by departing from the SAA.
Any group of assets with similar characteristics, that tend to move together in performance terms and are not perfectly correlated with another group of assets provide the opportunity for TAA.
Applying tactical asset allocation
Bottom-up managers must decide which individual securities to overweight and underweight. By then adding a TAA overlay to these bottom-up decisions, managers can deliver an uncorrelated source of out-performance and improve information ratios by increasing performance without necessarily increasing risk.
This building block approach is one of the key tenets of our Insight Alpha2 investment process, which considers the risk and performance potential of managers, TAA opportunities and how these inter-relate in a portfolio to maximise risk-adjusted returns.
Multi-manager portfolios which combine multiple sources of alpha from multiple managers, then enhance this with a TAA overlay can create very powerful risk adjusted performance. Returns are not diminished by combining managers with the same expected risk and information ratio - but overall tracking error is reduced (see chart).
The chart also shows how one TAA call is not as efficient as a small proportion of TAA positions at improving risk adjusted performance.
The optimal portfolio is a combination of multiple managers, with a TAA overlay.
The role of different asset classes
As previously stated, we believe the markets are inefficient, and can be exploited by applying macro views, valuation and growth measures to assess the relative attractiveness of an asset class.
We therefore believe that expanding the asset universe is another source of out-performance. This capitalises on the same principles outlined above but can also bring in asset classes such as real estate, commodities and hedge funds. Each one of these asset classes and sub sectors provide potential to improve the risk-adjusted performance of a portfolio. The illiquid nature, lack of information or divergence from peers which may be created by investing in these asset classes are all potential reasons for possible performance premiums from investing outside traditional asset classes (often we find that asset classes which are out of favour or uncomfortable to invest in provide performance premiums).
The FSA has now approved investment vehicles which can invest across all of these traditional and alternative asset classes in a multi-manager format, enabling retail investors to have access to new sources of potential out-performance.
Conclusion
We believe there are three broad ways for an investor to outperform standard asset classes:
l try to identify managers who can out-perform at the asset class level;
l tactically manage the asset allocation (TAA); and
l expand asset class selection. If stocks and bonds are not sufficient, look to expand the investment universe.
As long as markets remain segmented, and there are identifiable styles or regions where managers can be allocated to capitalise on the inefficiencies, we believe Tactical Asset Allocation will remain a good source of value and an attractive complement to stock selection and, when used efficiently, can produce attractive risk-adjusted out-performance.
