The question I currently find myself asked most frequently is: Should I sell US equities? It is a very good question, but in isolation its answer is insufficient to lead to an investment decision. Many investors agree that US equities are expensive and because of this believe the allocation should be reduced versus the strategic target. From a valuation point of view this is a good idea, as by most measures, such as the Price to Book ratio (P/B) or the Shiller Price to Earnings ratio (also called CAPE = cyclically adjusted P/E), US equities versus their own history have reached lofty valuation levels. At the same time, many investors overlook critical questions such as:
1. Should information beyond US equity valuations be considered?
2. How can tactical asset allocation insights like US equity valuations best be utilised in a portfolio context?
Before we address each of these questions, let’s revisit the basic facts on asset allocation. Asset allocation is broadly understood as the exercise of allocating between different asset classes, such as bonds versus equities, and different market segments, such as UK bonds versus Eurobonds. Holding any asset allocation for a long period is called Strategic Asset Allocation (SAA). SAA has a huge impact on the return outcome as well as the return variability, also known as volatility. A famous study by Brinson, Hood and Beebower(1) examines determinants of portfolio performance and its volatility. The key point to take away is that SAA on average determines over 90% of the return volatility. This is demonstrated in the following graph.
Corresponding results have since been confirmed by similar studies as Brinson et al(2). A study by Ibbotson and Kaplan into the impact of SAA on the return level(3), shows that empirically SAA was on average responsible for 100% of the return level outcome.
Nowadays more and more investors focus their investment efforts on SAA and implement it with cheap, passive index tracking products. That is a very good starting point but should investors stop there?
Both market timing and security selection represent active investment management. Market timing represents short term, Tactical Asset Allocation (TAA) decisions, like temporarily underweighting US equities versus the strategic US equity allocation. Security selection keeps the strategic US equity allocation but varies the weights of individual US stocks within the allocation to US equities.
TAA is traditionally implemented by tilting portfolios away from strategic weights during any year. This creates relative risk (tracking error) but also potential outperformance (excess return) versus the SAA portfolio. The relationship of both variables, excess return over tracking error, is measured by the information ratio, and the aim of TAA is for the information ratio to be positive. A 10% underweight creates a much higher tracking error than a 2% underweight but if the same good idea is applied (the same information ratio), there is potential for higher outperformance. Therefore, investors are required to have a very clear idea about how much tracking error they can withstand when markets don’t behave as predicted and that TAA generates significant underperformance versus a pure SAA portfolio.
Sizing an under- or overweight portfolio can have further implications on the absolute level of risk. For example, if an investor doesn’t like bonds versus equities because of low yield, should they reduce bonds from 50% strategically to 25% tactically? Alternatively, should the investor go all the way and not allocate to bonds at all; in other words switch to 100% equity? The latter will cause a far less diversified and much riskier portfolio. The following graph shows a 50/50 combination of two hypothetical assets, which both have a Sharpe ratio of 0.5 and a volatility of 10%(4): It illustrates a Sharpe ratio deterioration for tilting or switching, which is also larger for portfolios with more diversified assets or strategies (Fig. 2 lower correlations, left).
Therefore, a portfolio including TAA faces an uphill battle just to match the Sharpe Ratio investors would expect from it if no TAA would be attempted.
Let’s now look at using valuations in TAA decision making. In my opinion it is an absolute necessity to consider valuations. However, looking only at valuations can be equally as disastrous. For instance, some of you may remember the ‘TMT bubble’ at the turn of the century.
The below graph displays the Shiller P/E for US equities for the period of January 1881 to November 20175. In December 1995 US equities reached a Shiller P/E level over 25, well above the average level of about 15, which any investor could have calculated from all the data history between 1881 and 1995. 25 was also a level achieved only twice before in a period longer than 100 years. (Fig. 3, below)
Unsurprisingly in 1995 some investors believed that US equities were expensive and therefore started reducing their allocations to US equities. Unfortunately, in the following four years these investors had to experience significant performance headwind as valuation levels climbed even further!
After reading all of this, how excited are you about TAA? Most likely not a great deal. Nonetheless, I suggest to pursue it but in a very different, modern way that until now has predominantly been utilised by sophisticated, institutional investors. It involves the following: (Fig. 4).
Modern TAA combines many characteristics that all serve the main objective: to create positive risk-adjusted returns in most market environments. Firstly, modern TAA strategies are much more diversified. Gone are the days where a manager just shifts money between a few major equity markets or simply allocates between US equities, US bonds and US cash. Nowadays, TAA strategies explore global equity markets in much greater detail as they trade on country or regional equity indices from around the world, including liquid emerging markets. In bonds, futures on different parts of a yield curve are traded. Some strategies even explore credit spreads. Modern TAA strategies additionally allocate between different commodities, from energy contracts to agricultural, precious and industrial metals. They also pursue investment decisions between currency pairs, sometimes including currencies from emerging market countries. Some TAA strategies even trade volatility. In summary, modern TAA strategies have many options in which to invest.
Fig. 4:
Traditional | Modern |
Long-only | Long/short |
Unleveraged | Leveraged |
Physical Implementation | Derivative Implementation |
Valuation-driven | Multi-factor |
Main Developed Markets | Includes Emerging Markets |
Cash/Sovereign Bonds/Equity | Includes Currencie & Commodoties |
All these investments are pursued using derivatives. What sounds scary to an investor who has little or no experience with derivatives, is music to the ears of sophisticated, institutional investors around the world. Most of those derivatives have been used by investors for decades and many of them are standardised instruments traded on exchanges. They bring substantial cost advantages, as liquidity in most derivatives is very deep, sometimes even deeper than the physical market they are linked to. The crucial advantage here is that trading costs are relatively low, which in turn allows a manager to trade more frequently. Derivative usage also allows TAA investors to ‘short’ a market. This means that if the investment thesis is that the price will fall, establishing a short position makes it possible to turn such an idea into a profitable strategy. With shorting you can therefore significantly increase the number of ideas a manager can implement.
Now let’s talk about leverage. While leverage can often be a polarising topic, we believe there is a strong case for allowing it to achieve superior risk management. If an investor wants to have a noticeable impact on overall portfolio returns, modern TAA strategies would need very significant portfolio allocations, if those strategies would only target a small amount of risk. However, if modern TAA strategies can target a high amount of risk, investors allocating to them achieve a much greater degree of capital efficiency, as they can make much smaller allocations and nonetheless achieve the desired level of risk-adjusted return impact. Without leverage, that desired high level of risk could only be achieved by taking on much more equity risk than let’s say interest rate risk. With leverage, however, this objective can also be achieved but with exposing the portfolio to a high concentration of equity risk. Instead, modern TAA strategies can balance out the different risks they decide to hold in their portfolios.
Lastly, modern TAA strategies don’t focus all their attention on valuations any longer. Instead, they are multi-factor strategies that also seek to benefit from momentum, quality and/or low risk as well as carry concepts.
Below an explanation for each idea:
• Value – The tendency for relatively cheap assets to outperform relatively expensive ones
• Momentum – The tendency for an asset’s recent relative performance to continue in the future
• Carry – The tendency for higher-yielding assets to provide higher returns than lower- yield assets
• Quality, Low Volatility – The tendency for lower risk and higher-quality assets to generate higher risk-adjusted returns than high risk and low quality assets.
Going into more detail on each of these may be a topic for future articles. At this stage, it is critical to understand that a multi-factor approach is introducing an additional layer of diversification beyond the typical asset class dimension. This makes the return stream from modern TAA strategies even more robust.
Modern TAA strategies are a real improvement versus TAA strategies most people so far have had experience with. Still, no investment strategy can claim to be the ‘Holy Grail’ of investing as each strategy will undoubtedly have patches of negative performance and what is ‘state of the art’ knowledge today might not be tomorrow - modern TAA strategies are no exception. At this stage, however, I am confident that some of these institutional style, sophisticated strategies stand a decent chance to improve the odds of long-term positive returns of investors.
Sources
1 Brinson, G., Hood, R., and Beebower, G., (1986) “Determi- nants of Portfolio Performance”, Financial Analysts Journal, vol. 42, No. 4, pp 39-44.
2 Brinson, G., Singer, B., and Beebower G., (1991) “Determi- nants of Portfolio Performance II: An Update”, Financial Analyst Journal, vol. 47, No. 3, pp 40-48
3 Ibbotson, R., Kaplan, P., (2000) “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?”, Financial Analysts Journal, Vol. 56, No. 1:26-33
4 AQR,“AlternativeThinking”, FourthQuarter 2014 5 Online Data Robert Shiller: www.econ.yale.edu/~shiller/data.htm
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Helge Kostka, Chief Investment Officer Prior to joining MASECO Private Wealth, Helge helped to establish and grow the presence of Research Affiliates in Europe over the last 4 years. He began his career at Deutsche Bank in 1995, serving in a number of investment roles, including as head of qualitative alpha selection and head of portfolio engineering. Helge started at Aviva Investors in 2009, initially heading up the product specialist team in the areas of investment solutions, equity, and multi-asset and later establishing the respective product management function.
Helge holds a bachelor’s degree in finance and accounting from Hogeschool, Utrecht, the Netherlands, and a Diplom Betriebswirt from Fachhochschule fu¨r Oekonomie und Management in Essen, Germany. Helge also graduated with an Executive MSc in risk management and investment management from EDHEC-Risk Institute.
Helge is considered an expert in Smart Beta and quantitative investing, and has spoken at various conferences around the globe. Having worked with HNW individuals as well as large institutions in different jurisdictions, his rich experience allows him to bring institutional investment practises into the private client world.
In 2016 the Financial Analysts Journal (FAJ) published Helge’s co-authored research around factor and smart beta exposures. In March 2017 CFA Institute named Helge and two co-authors as the winners of the 2016 Graham and Dodd Award of Excellence via CFA Institute; it is the first time that a Chief Investment Officer at a UK Private Wealth Management firm has received such honour.
Contact: helge.kostka@masecopw.com