Strategic versus Tactical Allocation

Many market commentators have written about strategic asset allocation previously – the investment science behind the long- term allocation of investors’ capital across various asset classes. In our view, strategic asset allocation (SAA) is one of, if not the most important decision an investor can make when developing a portfolio of investments.

Monday, September 30th 2024, 10:57AM

by Octagon Asset Management

The logic surrounding SAA is straightforward; a rigorous observation of an asset class’s historical performance overlaid with some contemporary assumptions about future performance in order to approximate an investment mix that best matches an investor’s return and risk expectations.

But investing isn’t simple and expected returns are an average of historical returns, with all the ups and downs in-between. As the market knows, prices of financial assets don’t typically move in a straight line.

Strategic asset allocations are reasonably enduring, ideally set for somewhere between five years to a decade and potentially lasting as long as a generation, on the understanding that intra-period reviews are carefully considered and undertaken to ensure a fit-for-purpose SAA.

Tactical asset allocation (TAA), or the short-term deviation of the investment mix away from the longer-term SAA, is an approach active investment managers use to navigate through the ups and downs of financial asset prices.

The logic of TAA decision-making is about responding to opportunities, the known and unknown, either good or bad. The intention being to generate higher returns in favourable markets teamed with the aspiration to limit or mitigate losses when markets turn negative.

Most investors know that economic activity is cyclical, but how does an investment manager know that one stage of the economic cycle has been completed and that the next phase has begun? And by definition, who knows when the unexpected will actually happen?

TAA: Timing the market

What we do know is that markets try to predict the future based on previous results. And as we know, the past is not always a good predictor of the future. The first All Black’s test match of this season versus the Pumas had 7-1 odds for the Argentineans to win. Who knew if the Argentineans would do the job or not? In the end they most certainly did, but the odds offered were based on old data about both the ABs and Argentina. Markets, like athletes, get fatigued and when that happens, they’re usually vulnerable to a correction.

The local punter most likely relies on a gut feeling prior to making a wager, but an investment manager should take a more empirical approach to short-term investment decision-making.

Who knew that the Reserve Bank of New Zealand (RBNZ) would officially signal the conclusion to its multi-year tightening of monetary policy with a 0.25% cut to the Official Cash Rate (OCR) just a few weeks ago having reiterated hawkish sentiment as late as May this year?

While we’re guessing that most investors had a TAA over-exposure to domestic fixed interest, we’re not sure if there was market consensus as to when the RBNZ would begin easing monetary policy. Indeed, many market observers thought the RBNZ might start in August, and even more hoped that they would, but a lot of market commentators didn’t think they would move even that quickly. This uncertainty creates risk, and therefore opportunity, for reward.

Using the New Zealand Government 10-year bond as a general proxy for domestic wholesale interest rates and bond yields, an ill-informed investor may not realise that most of the super normal profits usually associated with a sustained fall in the OCR may have already be taken, in the immediate short term, at least.

Looking at the performance of the Bloomberg NZBond Composite 0+ Yr Index, a core New Zealand fixed interest market index. For the 12 months to 13 August the index has delivered a super-normal gross return (pre fees and tax) of 9.05%. An astonishing return for a core, go-to, domestic fixed interest strategy, especially when considering that this was the annual return up to the day before the RBNZ announcement!

Where to next?

As incongruous as it sounds, following so closely behind the dramatic easing in domestic monetary policy just announced by the regulator, we’re expecting active investors with more ‘hustle’ to view the recent move lower in domestic fixed interest yields as overdone, or overbought. Consequently, we believe some are actively considering or actually transacting their where-to-next strategy.

To be clear, there is no guarantee that any decision to partially exit or greatly reduce an investment relative to the Bloomberg NZBond Composite 0+ Yr Index will be correct. The RBNZ could front load its OCR cuts quicker than current market forecasts or an unexpected geo-political event could ignite the demand for safe haven assets, such as Government bonds.

We also acknowledge that some investors may prefer to assess price action against other, more preferred metrics. Here we’re thinking about the deviation between discounted cash flow valuations versus equity prices or the assessment of foreign currency rates against long-run purchasing power parity (PPP) values. Regardless, the principals of statistical analysis are the same – how does the current price or yield action empirically compare against the observer’s preferred metrics?

We think, given the significant returns to-date and our assessment of the fatigued price action of the New Zealand Government 10- year bond yield, that some active investors won’t see enough of a risk-reward opportunity to continue with an overweight TAA to New Zealand fixed interest.

It’s game-on for New Zealand fixed interest and we believe that any active investment manager should be well advanced in their where-to-next tactical asset allocation decision, ideally targeting an asset class that historically performs well once the easing cycle has actually begun.

Tags: Octagon Asset Management