BT: Tactical asset allocation models cut risks

Business Times - 14 Nov 2007

Tactical asset allocation models cut risks

ARJUNA MAHENDRAN examines the use of total return strategies as a way of riding out turbulent stock markets

THE stock market boom that started back in 2003 is expected to continue in the medium term. However, an analysis of longer-term market cycles shows that equity investors must brace themselves for more volatility in the short term.

Historically, bull markets have been spread over several decades. Examples of this are the sustained boom that followed the US Civil War and lasted until the beginning of the 20th century, the period after World War II to the end of the 1960s, as well as the phase from the beginning of the 1980s until the Internet bubble burst in 2000. These boom phases were all driven by fundamental innovations such as the railway, electricity, automobiles, aviation, and modern telecommunications.

By contrast, bear markets - when equity prices tumble as they did in 2000-2003 - tend to last two to three years, and result in cumulative losses of between 40 per cent and 80 per cent.

They historically turn into a new bull phase with relatively small and mild corrections in the first four to six years, the most recent of these periods probably being from 2003 to mid-2007. The second phase of a long-lasting bull market usually sees a correction of 15-20 per cent before the boom continues.

The current economic and societal changes clearly indicate the continuation of the bull market. New technologies (digital communication, nanotechnology), the rapid industrialisation of emerging markets such as China, and demographic changes (urbanisation in Asia, ageing populations in many industrialised countries) provide favourable conditions for growth.

However, concerns about dwindling energy resources, geopolitical tensions and environmental problems mean that it will not all be smooth sailing.

Investment strategies must, therefore, also factor in potential crises. In the current environment, the question is whether investors should adopt a passive strategy. Too much short-term switching in a portfolio will eat into returns, but a purely passive strategy when prices are falling could also lead to (book) losses of between 40 per cent and 80 per cent over several years.

Between 1926 and 2006, it sometimes took more than 20 years to earn a higher annualised return on Swiss equities than on Swiss bonds. The figures for the US tell a similar story. In the long run, equity investors are the most successful, but at the same time are exposed to considerable fluctuations in value. Investors with a strong stomach and the courage to buy in weak market phases can achieve handsome returns.

But the loss risk that comes from buying near the end of a boom phase should not be under-estimated. The markets are prone to exaggeration: One of the best-known examples is the equity and property bubble in Japan at the end of the 1980s when the Imperial Palace in Tokyo was estimated to be worth as much as the whole of California. Or the technology and Internet bubble in 2000 which saw breathtaking leaps in the market capitalisation of companies that often did not turn a profit and in some cases did not even report any turnover.

Our analyses show that simple indicators such as seasonality (sell in May and go away), momentum, central bank monetary policy, and interest-rate structures on the capital markets can be a useful source of investment tips. A combination of these factors has led to higher returns with a lower downside risk.

These results suggest that sophisticated tactical asset allocation models can offer attractive returns while at the same time substantially reducing the loss risk, otherwise known as total return strategies. Total return, or absolute return, strategies have two objectives: to achieve a minimum return, often equal to the money market return plus 2-3 per cent; and at the same time to minimise the loss risk. Most of these strategies aim to generate a positive return over a 12-month period.

Total return strategies draw on a dynamic investment approach and diversification to reach their objectives. Demand for these strategies tends to increase when the markets become volatile.

Relative return strategies, by contrast, track their performance against a benchmark. This approach means that fund managers can beat the benchmark despite making net losses for their clients, for example, if the fund loses 12 per cent but the benchmark index falls 20 per cent.

The situation is reversed if the total return strategy achieves 10 per cent while the equity market gains 20 per cent in a given year. Investors must be aware that it is not only the returns that vary; the risks are also different.

In practice, total return and relative return strategies are not mutually exclusive. Many clients want active risk monitoring for part of their investments, but at the same time are mindful of the returns achieved in relation to traditional investment forms such as equities and bonds.

Arjuna Mahendran is chief economist and strategist, Asia-Pacific, Credit Suisse Private Banking