The structural misallocation of assets within an entire portfolio is the most pertinent reason for losses suffered by investors over downward phases of the business cycle, and inadequate returns over upward phases of the business cycle, within the bounds of the investors risk appetite.
The problem manifests itself in two areas, namely in portfolio structure, and secondly in the psychological reaction of investors. Fragmented portfolios, static portfolios and portfolios switched for the wrong reasons into inappropriate funds are generally the underlying causes of asset misallocation in portfolios.
The psychological reaction at points along the “cycle of market emotions” is a further factor in the fundamental cause of losses in investor portfolios. Investors impatience with the effects of the business cycle, leads to extreme optimism and pessimism with its concomitant reactive decisions.
Attempting To Solve The Problem
Adopt a six-step process to solve the problem.
- Undertake a risk and life stage analysis to determine the enthusiasm for risk, and the proximity to capital requirement or retirement date.
- Secondly, assess the current situation in terms of all the assets invested.
- Thirdly, consider the current asset allocation against a template of the desired asset allocation model.
- Fourthly, migrate to appropriate funds from a predetermined fund universe considering the position on the business cycle.
- Monitor results on an established basis and adjust the asset allocation model to consider the new business cycle factors.
- Lastly, communicate outcomes regularly.
This process standardises actions, utilising investor, and environmental factors to achieve optimal asset allocation strategies and ultimately, optimal returns.
Defining The Problem
In writing this document, I have tried to communicate in reasonably simple terms, so that a non-financial reader would have a clear understanding of the facts.
Financial markets, are fickle, and have no masters. Finance ministers try to restrict and expand the economy by means of budgetary leverage, as do the Reserve Bank governors, using interest rates as their lever; and yet, these actions can only at best influence the duration of the business cycle. It is this realisation then, that brings us to the problem of allocating appropriate asset classes, such as cash, bonds, property and so on, to satisfy the needs of the investor over the business cycle.
The problem is twofold; firstly, in terms of structural allocation, and secondly in the psychological or emotional reaction of the individual client.
Structural allocation, or more appropriately, misallocation, refers to a dearth of attention to the portfolio in its entirety, the chasing of the “flavour of the moment” strategy, and amongst others, switching from losing positions to perceived winning positions.
The fragmented portfolio
Most portfolios, are unstructured, and do not take into account the entire asset composition of the individual investor. For example, Investors take out policies over the various stages of their lives, and invest ad hoc amounts, as these become available. Rarely does a financial advisor take all the underlying asset classes of these investments into account when recommending the marginal or latest investment. The problem with this is that the investor inherits a basket of incongruent asset classes, mismatched to his or her risk profile, and totally oblivious as to the gradient of the business cycle.
The static portfolio
The previous decade presented us with an array of investment opportunities, for various underlying reasons. Firstly, the bull equity markets, then the opportunity to invest offshore, after that the volatility of the last quarter of the previous decade, next, the property boom. If this sounds familiar, then you probably have a portfolio of equities, offshore investments, some hedge funds, structured funds, and lately property funds. All the investments where probably effected, because they were made during the sway of that particular fad. Nothing was changed, or probably taken into account when the new investment was made. All the previous investments therefore remained static, and where not brought into line with the current reality.
The eternal chase for performance makes investors, and their advisors do strange things. Ideally, a switch should be made from a peak to that of a trough, followed through to the next funds peak then out again, for maximum financial gain. Few investors actually get this right. This is a problem in timing. Timing is fortuitous and extremely risky. The general pattern that is gleaned is one where investors switch out of a losing investment to one that is just about to peak, repeating this losing strategy over and over. Chasing the flavour of the fashionable is hardly a winning strategy, and has been proven repeatedly.
The business cycle, with its concomitant manifestations, such as variant interest rates, exchange rates, tax rates and asset values, should be the driver of the asset allocation strategy, which in itself, should be elastic over the curves of the cycle. Unfortunately, this is not ordinarily so, as psychological factors impact severely on investor decisions and therefore returns.
The business cycle; optimism, and pessimism.
The peak and trough of the business cycle represents the starting block of over-optimism and ultra-pessimism respectively.
The business cycle and psychological profile
The graph above depicts point A as being the point of maximum optimism, and point B as being the point of maximum pessimism. As can be seen, the psychological euphoria and despondency respectively, exceed the bounds of the business cycle shown above in black. The reality is that investors feel most positive in purchasing or switching to the market up to point A, when the business cycle has already turned downwards at the intersection. This leads to over-inflated prices, which tend to dissipate at the slightest hint of negative information or rumour. The inverse is true at the trough. Investors should cautiously be entering the markets at the intersection, but are reticent, and will only consider doing so much further up the curve, thereby foregoing valuable returns.
The cycle of market emotions
It is appropriate at this point, to introduce a well-known graphic representation of the emotional roller coaster of the unprepared investor. The input of Stanlib and Westcore funds is acknowledged.
The cycle above, although anecdotal, represents the unsuspecting investor, who is compelled to ride the business cycle to regain his or her capital. The strategy of diversification and appropriate asset allocation cannot be sufficiently stressed.
As stated previously, and somewhat paradoxically, the point of maximum financial risk, is also the point at which most investors, become pertinently aware of the asset class, and switch to, or purchase into it. The converse is again true at the point of maximum financial opportunity, when most investors have lost all hope and commensurately their appetite for this asset class.
Attempting to solve the problem
Volatility and unforeseeable triggers have shifted fundamental analysis off centre stage. It is even more important today to target positive returns in excess of inflation than tilting at high risk, single or even duel asset strategies. It is only a well-spread and elastic asset allocation model, that itself is bound to the ever-changing business cycle, which will ultimately achieve consistent, positive, inflation related returns. This then is also our stated objective.
The process is as follows;
Risk and life stage assessment
The first step to achieving our stated objective is by determining the risk profile of the investor on a regular basis. The need for this stems from the fact that risk is perceived differently at different stages of the business cycle, and naturally, at different ages. The risk profile is attained via a questionnaire and the life stage assessment is determined by the stated and desired retirement age of the investor. The investor is then categorised in terms of four broad mandates, namely, guaranteed, conservative, moderate, and aggressive. The life stage strategy determines that funds are migrated to the guaranteed portfolio over five years prior to retirement, effectively rendering the portfolio free of market risk in its final year prior to retirement.
The portfolio needs to be integrated. For this to happen, a holistic assessment is conducted, to determine all the existing portfolios and asset classes that the investor is invested in. This includes all insured investments, unit trusts, offshore investments, and funds on the various platforms available, amongst others. The modus operandi is to determine the nature of the underlying portfolio, and categorise it in terms of the asset classes adopted under this assessment. Only once this is done, can one proceed to rearrange the proposed and existing funds in terms of the dynamic asset allocation model and the underlying funds.
Dynamic asset allocation
The dynamic asset allocation model is the term proposed for the allocation model, which tracks the curves of the business cycle as closely as possible. Due consideration to the cost-benefit relationship of switching needs to be given, so that the gain of the switch is not negated by the cost thereof. This implies that the asset classes will only be adjusted once the magnitude of the perceived gain is sufficient. The term Asset Allocation Model, is the term given to the allocation of asset classes for a particular risk classification. The term Dynamic Asset Allocation as used in this document, implies that the assets are distributed according to the risk profile of the investor, as well as the current position of the business cycle.
An Asset class represents a fund genre, which has the same or similar properties. All money market funds have the same objective and have the same feel about them, as do property funds and bond funds. In the South African context, six asset classes will be allocated. These are, starting at the lower end of the risk spectrum, Cash, Bond, Property, Alternative Strategy, Equity, and Off Shore rand hedge investments.
Asset allocation is the efficient allocation of the class resources to the investors to the risk profile of the investor. Herewith the current version of the strategy. It must be stressed that the there is a distinction between the allocation of compulsory or retirement fund monies, and discretionary investments. Retirement funds are subject to the prudential investment guidelines, and the strategy encompasses this.
Dynamic asset allocation
Dynamic or cyclical asset allocation is the re-allocation or elasticising of the asset classes with specific reference to the business cycle.
Asset allocation is the driver of performance. Fund selection needs to be seen in that context.
In many cases, the possibility of poor returns, relative to the mean of all the asset specific returns, can be obviated by utilising Index funds. It is a fact, that over specific periods, Index funds have been, and are still top quartile performers. The issue of costs also exacerbates the problem of active fund managers.
In the South African context, the problem, in particular with equity trackers or index funds, is that they invariably track the top end, large capitalisation stocks, which are mainly resource focused. This means that the index is invariably skewed to the resource sector. For this reason, high quality fund managers are preferred. The criteria for selection, is a three-year top quartile, consistent record of accomplishment using the Plexus survey of fund managers as the managers universe.
Results need to be monitored on the following basis.
a) Business cycle determinants and manifestations on a monthly basis
b) Mean asset class returns on a monthly basis
c) Fund returns on a monthly basis
The asset allocation strategy is reviewed quarterly or as circumstances demand, and adjusted when necessary. Fund choices will also be reviewed monthly, and will be switched as necessary, with due regard to costs.
The problem with feedback, is that it is periodic, and a snapshot of one or two portfolios at that specific time. The object is to consider holistically the entire portfolio of all investment assets and this can only realistically be done meaningfully, annually. Most investment platforms allow Internet access to client’s portfolios with meaningful information. Returns need to be seen in context and over a reasonable period. The immediacy of information has positive as well as negative implications. The negative implication manifests itself in the nature of the investor, and can cause him or her to react on short-term variations thereby making any potential losses permanent.
Most of the recognised platforms are used. Endowments and Retirement annuities are also used on the linked provider platforms, as the tax advantage warrants. Costs are necessarily taken into account as are the benefits provided by the product provider.
We do not take fees upfront, which enables the fund to grow from day one! Our only fee is a .75% ongoing charged 1/12 monthly.
The commitment from this advisory service is to provide excellent financial solutions, based on the premise of this document. The primary intention is capital preservation and consistent inflation beating returns. The temptation to pursue whimsical trends and rumour is not part of this strategy, adherence to the principals, is!
The premise as stated above is subject to relevant and timely information from the South African Reserve Bank and Statistics South Africa.
This document was produced by Mike Papageorge
B Com MBL FILPA