Tactical asset allocation has rarely been so difficult. Many of the investment managers who have struggled in the past few years would contend that their fundamental analysis of financial markets will be proved right in the end.
Government bond markets are indeed in an unsustainable bubble, equity markets are undervaluing those companies with high growth potential and the lid will eventually fly off the inflation pressure cooker as more and more liquidity is pumped into the banking system.
But in the meantime their accurate fundamental analysis is being overwhelmed by the technical reality of sentiment and weight of money.
The opportunity cost for investors can be material. How long should an investor stick with a manager who is fundamentally right but technically wrong?
Let us consider the performance of two groups of investment managers – private client and charity – and compare their performance with that of the FTSE Apcims indices, a set of indices designed among other things as benchmarks for assessing and comparing the performance of discretionary managers.
In the past three years, the vast majority of private client discretionary portfolios have recorded lower returns than the comparable FTSE Apcims index. In fact, a passive index-tracking strategy replicating the composition of the FTSE Apcims indices would have placed a manager in the top 10 per of the peer group. So where did private client discretionary managers go wrong?
The common themes are an over-cautious stance with respect to equity markets and a lack of exposure to UK government bonds. In the aftermath of the financial crisis in 2008, with the benefit of hindsight, private client discretionary managers placed too much emphasis on capital preservation strategies thereby capturing only part of the ‘relief’ rally. Then, with a focus on absolute return, they eschewed investing in a manipulated government bond market with the prospect of negative real rates of return, taking comfort in the knowledge that government bonds only offered ‘return-free risk’. Yet yields fell still further.
In contrast, a focus on regular and reliable income meant that charity managers were more inclined to retain exposure to longer dated gilts in spite of the low yields. It also meant that charity managers tended to hold a higher exposure to defensive, internationally diverse equities – those offering modest but steady growth, visibility of earnings and high dividends. The income imperative translated into superior overall investment returns.
So what is the outlook for 2013? In the long run, fundamentals dominate technical factors in determining asset prices. But as JM Keynes famously quipped, “in the long run we are all dead”.
For investors, the unknown variable is how big the liquidity bubble can become before it bursts, and that is at the heart of the tactical asset allocation conundrum facing investment managers today.
Graham Harrison is managing director at Asset Risk Consultants
