Increasing returns through dynamic asset allocation

Stanley Yeo, IOOF Portfolio Manager, Strategy and International Equities

What is dynamic asset allocation?

Dynamic asset allocation (DAA) describes active portfolio management from a macro, or top-down, perspective. The process aims to generate additional returns, or reduce portfolio risks, by reallocating funds when markets deviate from ‘fair value’. DAA enhances a fund’s strategic asset allocation (SAA) which uses equilibrium assumptions to provide long-term asset allocations by introducing a more flexible framework to increase exposure to under-valued opportunities while reducing exposure to overvalued assets.

The vast majority of investors have a long-term SAA that is constructed based on their specific return objectives and risk criterion. The SAA is of fundamental importance in the determination of their portfolio’s return distribution. However, the long-term nature of an SAA requires long-term assumptions around return distributions. Due to lengthy forward assumptions the SAA doesn’t lend itself to taking advantage of short-term opportunities. This is where a DAA process plays an integral role in increasing returns, or reducing risk, to achieve portfolio objectives.

How is DAA beneficial?

A dynamic asset allocation process may resolve some shortcomings of the strategic asset allocation portfolio. Most importantly, the DAA process allows a portfolio to reflect new information and potentially adjust the asset allocation accordingly.

Decades of research has confirmed that asset allocation is the overwhelming determinant of portfolio returns in a diversified multi-asset fund. As such, investors should focus on asset allocation decisions when market conditions change. A fund’s inability to change its asset allocation when market conditions dramatically change can lead to unrealised return expectations, inefficient portfolios, unexpected volatility, and tail risks. We believe a dynamic asset allocation program that adjusts expectations by incorporating new information allows for a higher probability of achieving return expectations and better risk management.

Where are the current DAA opportunities?

Equities

We feel comfortable that provided the US does not fall into recession – which we believe is unlikely to occur over the next couple of years, markets will eventually look beyond short-term headlines and return their primary focus on the merits of fundamentals of individual securities. Indeed, overreaction by financial markets to short-term negative news headlines often creates attractive investment opportunities for disciplined long-term investors.

We remain generally constructive on the prospects for global equities due to a host of factors such as further declines in unemployment in key regions, an improving wage outlook for a broader segment of the global economy and the resiliency of corporate profitability.

Therefore, while we foresee modest global equity returns for the long term, it remains our conviction that investors may be better off investing in this asset class rather than in government bonds and cash.

Emerging markets

One area of attractive valuations for investors is emerging markets. Emerging market currencies took a beating in 2015; yields are high; equities are cheap; profits are at cyclical lows and monetary policies are overwhelmingly stimulatory. Risks are still high however, with a number of these regions afflicted with collapsing commodity prices, or otherwise in recession. Debt levels are high and dangerous and we may not be quite through the woods with this investment opportunity just yet, but it does provide a value candidate amongst an expensive investment universe. Furthermore, the trade slump in emerging markets has deepened with South Korea and China both experiencing double-digit export declines. Although fundamentals may not currently be strong enough to overweight this sector, we will be watching this closely in 2016.

Australian dollar

It has been another strong year for the USD, which is no longer cheap, but central bank policy divergence and further emerging markets weakness mean the path of least resistance should be upwards. A strong USD is the market’s consensus call, so there is risk that central bank divergence has been priced in. The USD could fall if the US economy turns out significantly weaker and prevents the Fed from tightening. On balance, however, we believe there is further upside to the USD coupled with further AUD weakness. At current levels, we believe the Australian dollar remains expensive relative to a fair value measure that takes into account the deterioration in Australia’s term of trade.

Fixed interest

Although the US Federal Reserve (Fed) has increased rates, the market is pricing in a very slow pace of tightening – consistent with the Fed’s median forecast. This presents a risk that rates could rise faster than is expected. The market will be focused on the pace with which the Fed raises rates. It is reasonable that investors are questioning the outlook for bonds, especially when you consider prevailing low rates and tight yield spreads. From these levels, investors should expect bond returns to be fairly modest in 2016. However, bonds still have a very important role to play in an overall portfolio: generating income, preserving capital, and providing diversification relative to stocks.

How are we positioned?

With the above in mind, the MultiMix Balanced Growth Trust maintains its overweight to global equities with a view to increasing its exposure to the emerging markets when fundamentals improve. Within global equities, we remain fully unhedged. We maintain an underweight to fixed interest, where we are short duration versus the benchmark and overweight credit.

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IOOF MultiMix Balanced Growth Trust is a finalist for the multi-sector and asset allocator of the year in the 2016 Money Management/Lonsec Fund Manager of the Year awards. Find out more


Important
The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.