29 Oct 2024
.jpg)
Article written by the PSK Investment & Research team
An asset class is a group of securities that have common characteristics that are distinct from other asset classes. These common characteristics refer to the underlying economic drivers of cash flows as well as how the asset is expected to behave in different market environments.
Asset classes are traditionally divided into ‘defensive’ assets, and 'growth' assets. Generally speaking, 'growth' asset classes, such as equities, property and infrastructure, are assumed to achieve higher returns on average than defensive assets. However, growth assets tend to have wider possible variation around that average. Conversely, 'defensive' asset classes, like cash and bonds, are assumed to have lower average returns than equities, but with less variation. Alternative asset classes / strategies generally exhibit elements of both defensive and growth characteristics and can be funded from the defensive or growth side of the portfolio depending on the strategy in question.
Strategic Asset Allocation (SAA) is the primary position or base case for the proportional allocation of capital to respective asset classes in a portfolio constructed to optimise returns for a given level of risk. The SAA is determined based on expected asset class returns, volatility, and correlations (i.e. the relationship between asset classes) which in turn are largely guided by history.
Dynamic Asset Allocation (DAA) is a secondary consideration in portfolio construction. Its application is to add value (increase return, reduce risk, or both) for a portfolio by deviating away from the SAA and taking dynamic or short to medium-term under/overweight positions in an asset class or sub-asset class when a suitably attractive opportunity is identified, or concerns become more apparent.
Dynamic Asset Allocation Framework
Asset Allocation is a major driver of returns for a portfolio. A range of academic studies suggests this factor contributes somewhere between 70-90% of a portfolio’s return. Consequently, appropriate implementation of some active asset allocation to reflect strategic biases in the portfolio can potentially improve the overall portfolio return on a risk-adjusted basis.
The strategic biases we identify within the dynamic asset allocation framework are expected to be investable across the medium term and exist for at least 12 to 18 months. Shorter term biases (i.e. 6-12 months) may also be employed where there are severe market dislocations or expectations of dislocations, and a sufficient enough case exists. These are rarer given the timing of these becomes increasingly difficult the shorter the time horizon.
Effective implementation of these strategic biases in portfolios is also dependent on the availability of suitable investments. Furthermore, portfolios are constructed and managed on the basis that they can be adjusted on a regular basis.
The dynamic asset allocation framework is largely built with a 6–18-month time frame in mind and is produced monthly but formally reviewed quarterly, with valuation, macro, and momentum factors equally driving outcomes. The macro factor, whilst fundamentally based on current and relevant data, is rather subjectively utilised. The momentum factor is our most objective, whilst the valuation factor is mostly objective with a subjective overlay given we don’t delve down into sub-sectors, individual countries (outside of Australia and the USA), and market segments.
The Valuation framework is conducted both on an absolute and relative basis. On an absolute basis, we’re focused on assessing the current valuation of an asset class against its longer-term average valuation. On a relative basis, we’re focused on assessing the current valuation of an asset class against other asset classes; and the asset class against itself under a variety of historical conditions / environments. The overarching focus here is on absolute valuations, with relative valuation being used to connect the macro and the momentum factors we look at.
With regard to the Momentum factor, we’re really looking at valuation support (or lack thereof) in terms of trends in price movements, investor sentiment, and external factors that may either support or remove momentum from a particular asset class. For example, in terms of investor sentiment, we’re looking at news headlines, asset class flows, and signals from multi-asset / global macro investors / fund managers. The primary driver of this factor in our framework is short-term momentum.
With regard to the Macro factor, we’re really looking at the operating environment right now, but also contrasting that with the history and the outlook ahead. We’re focused on macro factors such as currency, interest rates, central bank policy, government fiscal policy, underlying broad economic data, government policy, etc. The focus here is how the current levels and future movements in these factors may hinder or help a particular asset class on a forward-looking basis (12 months).
As mentioned previously, the momentum and macro factors assist from 2 main perspectives:
- Help to explain why an asset class is trading above or below historical valuations, and whether that is likely to persist.
- Help to provide guidance on the magnitude of the DAA settings relative to the neutral position (i.e. conviction levels).
Whilst the DAA framework has plenty of flexibility and subjectivity built into it, the intention is not to make changes overly frequently and not to use the full bounds of the parameters built into the framework. Where portfolio changes are driven by a change in the framework, the changes are generally up to +/- 20% at the defensive / growth level and up to +/- 10% at the underlying asset class level.
In addition, the flexibility built into the DAA framework is subject to the available investment opportunity set. There may be times when DAA positioning may need to be adjusted due to the lack of available product sets.
The Investment & Research team at PSK are always monitoring market conditions and data points to ensure portfolios align with our overall long-term objectives. If you’d like to discuss any of the points raised, please contact your Adviser or call us on (02) 8365 8300.
General Advice Warning - Any advice included in this article has been prepared without taking into account your objectives, financial situation or needs. Before acting on the advice, you should consider whether it’s appropriate to you, in light of your objectives, financial situation or needs.
