Investors need to consider the interaction between an asset’s volatility, relationship with other asset classes, and the strength of your own market convictions when sizing dynamic asset allocation tilts, according to Frontier Advisors.
For example, a fund holding an equal conviction in bonds and equities would require a much larger tilt to bonds to offset that asset classes’ greater volatility, according to Frontier Consultant, Daniel Selioutine.
“Roughly, a 1% tilt to equities is about equivalent to a 5% tilt in bonds, is approximately equivalent to a 3% tilt in unlisted assets – and that’s largely what we’ve seen historically,” he said during a panel session on the topic at the Frontier Advisors annual conference.
Without the ability to perfectly predict markets, diversification between DAA tilts can partially reduce the impact of incorrect tilts. A rule of thumb is that two times the volatility is equal to the approximate deviation under extreme market conditions. Another challenge in scaling DAA tilts occurs when one portfolio (such as a particular member investment choice) lacks an asset class.
Nonetheless, while it is a complex area, funds can apply their same regular portfolio analysis tools and techniques to DAA tilt portfolios, which have the same risk and return correlation assumptions over time.
“All of these tools that you’ve come to know and love in standard portfolio analytics are actually readily applicable to DAA portfolios,” Selioutine said. “The only difference between a standard portfolio and a DAA portfolio is that a DAA portfolio doesn’t add up to 100 – it adds to zero because all of your underweights have equal and opposite overweights.”
Michael O’Dea, Head of Multi Asset at Perpetual Investments, said conservative investors are facing an unprecedented challenge given their historical preference to use bonds – an asset class now struggling to match inflation – to protect capital over shorter time horizons.
“I believe that dynamic asset allocation has a very clear role to play but I would say that one size does not fit all portfolios.”
Sentiment, as well as market value, plays a greater role for conservative investors than longer-term investors who can ride out market swings. O’Dea says these type of conservative portfolios require more continuous portfolio management, may use derivatives for downside protection, and should be broken up by risk factors rather than asset classes.
“I don’t believe that your starting point for SAA should determine your active asset allocation positions – I think the two things should be thought about independently. You should be looking to build the most diversified set of active asset allocation positions that you can.”
O’Dea said optimal diversification of active risk could be achieved by separating alpha and beta decisions, treating FX as a separate decision, and looking at different implementation options (active, passive, smart beta, physical or derivative). However, investors should also retain a number of active managers in each asset class and include investments in diversifiers such as alternative beta and hedge funds.
View the slides from this session here.