Multi-sector portfolio managers use a range of approaches and investment styles when managing and investing money and a portfolio’s strategic asset allocation (SAA) is always a major focus.
A portfolio’s SAA is constructed in a way that maximises the probability of achieving a return objective over a given longer-term horizon. For example, an SAA for a typical balanced portfolio may include a 20-40 per cent allocation to Australian equities, a 20-40 per cent allocation to international equities, a 20-30 per cent allocation to cash and bonds and a 10-20 per cent allocation to other assets, including alternatives and other unlisted assets. The investment manager will manage their portfolio with the intent of keeping their allocation to those asset classes within those bands.
However, investment markets are not static. With recent events particularly front of mind, we know that markets can be extremely volatile, with assets performing differently to the longer-term assumptions used in the SAA.
This is where dynamic asset allocation comes in.
What is dynamic asset allocation (DAA)?
Increasingly recognised as a valuable portfolio construction option, DAA seeks to enhance returns and smooth risk by altering the short-to-medium-term weightings to assets based on factors such as valuations, the business cycle, policy developments and other major events. It’s about tilting a portfolio away from the underlying SAA – typically something fixed for a long period of time – in order to take into account major macroeconomic changes, policy developments and changes to asset valuations.
A dynamic asset allocator considers the potential risk to portfolio positions and how markets might move over a three-month to two-year horizon. Remember, the SAA for a portfolio reflects return and volatility assumptions over a 5–10-year period typically.
Need to know:
Tactical asset allocation (TAA) is sometimes used interchangeably with dynamic asset allocation (DAA). However, TAA generally involves decisions made considering a much shorter time horizon than DAA.
The other important thing to note with DAA is that investors shouldn’t be moving their actual portfolio positions outside of the range they would have expected from their SAA. If an investor is in a conservative portfolio, DAA does not involve taking positions that push them up into a balanced or a growth-type portfolio setting.
DAA in action
Over the past few years through the COVID-19 pandemic, we’ve been quite active in terms of DAA recommendations. As COVID-19 struck early in 2020, the goal was reducing portfolio risk where possible. But as the economy and markets adapted to the risk, with central bank and government policy support, the DAA process made it possible to take advantage of these changes. The best DAA strategy at that point involved an overweight position in equities, mainly at the expense of bonds and cash.
From mid-2021, the DAA strategy has been more about trying to cut back on risk in portfolios, initially because the indicators of growth momentum had peaked but more recently because high inflation has raised the risk of central banks tightening policy to an extent that undermined the growth outlook.
The prospect of higher bond yields and extreme valuations meant reducing exposure to assets like US equities and more recently, real estate investment trusts (REITs). From a DAA point of view, it’s important to identify where the risks and opportunities might be. Since the highly stimulatory policy response to COVID-19 in 2020, the view is that inflation risks were rising and the response was to be underweight bonds. There has also been a move to be underweight corporate credit in the belief that credit was priced for perfection and vulnerable to rising rates.
One of the positions we've adopted from late 2021 was a preference for Australian equities over global equities, based on relative valuations but also Australia’s greater exposure to commodities. Although both markets are down, the relative outperformance of Australian equities has worked reasonably well for our clients.
Of course, not everything has gone to plan. Based on our commodities view we were predicting the Australian currency would strengthen, but that hasn’t eventuated yet. In hindsight, a more significant underweight position to equities would have benefited portfolios.
Three key things to remember about DAA
1. Understand the objective of the DAA program
DAA is not so much about adopting massive deviations from a client’s longer-term SAA and trying to achieve huge outperformance; rather it’s about trying to enhance returns and minimise risk. For instance, a goal may be to generate a return of 50 basis points per annum over an SAA benchmark over a full cycle.
2. A consistent process is important
It's important to not be thrown by the narratives of the day. A data driven approach and a set of rigorously formulated signals which are modelled and tested helps ensure this. Developing a range of indicators and signals over a long period of time and across different market conditions assists in the decision-making process. These are updated and reviewed day to day, week to week, culminating in a monthly DAA report. This combined with a monthly meeting with a senior investment team, where the process is reviewed and decisions and recommendations are voted on, ensures this data driven approach.
3. Different factors work at different stages
A combination of valuations, policy and liquidity conditions, the business cycle position and shorter-term momentum help determine DAA tilts. The factors tend to operate over different time periods; for example, markets may appear expensive on the valuation signals but may remain well supported due to policy settings and the macro backdrop. The challenge is to try to understand when or the likelihood that the policy and/or macro environment will have changed sufficiently to expose already expensive valuations. And to create a consistent framework within which to look at DAA.
Uncertain times
This current period is perhaps one of the most interesting periods in years for asset allocation. The longer-term drivers of the disinflation and of low and declining interest rates we’ve experienced over recent decades may be in the process of changing. Demographic changes, productivity trends, de-globalisation and geopolitics tend to shape the broad growth and inflation outlook over the long term.
There are also cyclical challenges, as we’re facing now. Central banks are trying to deal with rising inflation through higher interest rates, However, if they push too far too soon, there’s the possibility of recession risk. A DAA approach needs to be hyper-aware of these risks when it comes to portfolio positioning. That’s the key challenge for asset allocation in the current environment.
