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Applying a Value-Oriented Approach to Asset Allocation

Updated: May 17, 2022

We employ two types of asset allocation: strategic and tactical. The strategic asset allocation for a particular fund represents the long-term framework commensurate with the fund’s investment objective. The framework is structured in the form of a series of weightings to various asset classes and markets. We make various assumptions for how these asset classes and markets are likely to perform in real terms over the long term. The strategic asset allocations do not tend to change, since fund objectives and long-term performance assumptions don’t tend to change, but we review them every June.

"Cycles in the real world are not quite as neat as they are in theory"

Around these strategic asset allocations, we apply tactical asset allocations. For example, the strategic asset allocation weight for our investment trust in Asia Pacific ex Japan equities is 8%, but we may choose to have an allocation of 9.5% (this is in fact the current tactical target). We choose to be overweight in relation to our strategic asset allocation because I, as asset allocation specialist, believe that returns from Asia ex Japan equities will be above average over the next few years.

My framework for assessing the merits of various asset classes and markets is based around business cycle analysis as well as considering various valuation numbers. Valuations and the business cycle are closely related, but they can be analysed separately.

As for the business cycle, I assess where a particular country is in relation to its cycle by looking at economic indicators that help me determine whether activity is high or low, and whether it is rising or falling. Low and falling is called the ‘recession’ phase of the cycle, low and rising ‘recovery’, high and rising ‘expansion’, and high and falling ‘peak’. It has been documented that different asset classes tend to perform differently during each phase. For example, equities perform worst during ‘peak’ phase, bonds worst during ‘expansion’, and commodities worst during ‘recession’. Although cycles in the real world are not quite as neat as they are in theory, they can still on the whole be discerned. For example, if you take a look at the unemployment rate in a particular country, one can see patterns that are clearly not random. If there is pattern, there is scope to make money from tactical asset allocation.

I do also look at valuations both to verify where we might be in the cycle, as well as to assess whether a market or asset class is cheap. However, valuations must be viewed in the context of other metrics such as short term real interest rates, rather than in absolute terms. For example, equities may look fully valued, but if real deposit rates are negative, valuations can continue to rise (it is generally only when real interest rates become attractive following a period of monetary tightening, that equities will lose their appeal).

So, where are we at the moment? Long-term real interest rates across the developed world stand at around -1%, which makes bonds unattractive. Thus we have a zero tactical target in developed market investment grade bonds. Developed economies are on average reaching the end of the ‘recovery’ phase, so equity returns will start to fall. Consequently, we expect to reduce our equity targets progressively for the next two or so years, in anticipation of a downturn in 2020. Like driving, you should slow down as you approach a bend rather than when you reach it.

Published on LinkedIn

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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