For investors with clearly defined return targets in mind, such as saving for retirement, having the appropriate combination of asset classes in their portfolio is considerably more important than choosing the best performing managers or high-flying stocks.
This is according to Izak Odendaal, Investment Strategist at Old Mutual Multi-Managers (OMMM), who says that the right mix of asset classes can help you reach your investment goals while still reducing risk.
“In a Targeted Return Strategy, the approach is to achieve real and clearly defined returns while still minimising volatility as far as possible. To do this, we start by studying the longest available historical returns for each asset class, and allocate assets in a way that is most likely to achieve the target with the least amount of volatility. This we call the Strategic Asset Allocation (SAA), and there is an SAA for each strategy and fund.”
Odendaal explains that, in theory, investing according to an SAA, and leaving it over the appropriate horizon for each strategy, offers a very good chance of achieving the return target. “It is the type of asset allocation that performs over the long term. However, markets are dynamic and over the course of one, three or five years, asset allocation cannot be based on their average performance over the past 100.
“The volatility and return profile of each asset class is driven by the performance of the economy, movements in the exchange rate, changes in interest rates and crucially, investor sentiment,” he says.
According to Odendaal, it is therefore also necessary to apply Tactical Asset Allocation (TAA) to a strategy, in order to position it based on where the returns are likely to come from in the future. “In other words, we will tilt our positioning in each asset class relative to what the SAA suggests. This entails comparing the current valuation of an asset class with where it has historically traded, as well as where it should trade based on the underlying economic reality. If the current value is below where we think it should be, the asset class is undervalued and consequently more attractive.”
INVESTOR BEHAVIOUR CREATES OPPORTUNITIES FOR ADDING VALUE
Odendaal believes that investor behaviour often causes valuations to significantly diverge from fair value, both on an asset class, and individual shares level. “Simply put, investor sentiment can swing from optimistic to pessimistic without any meaningful change in the underlying economic reality. There are a host of other well-documented behavioural biases, cognitive shortcuts and emotional responses that result in inefficient markets. This creates room for active management to add value.”
He adds that for each asset class, the valuation metrics applied differ. “For example, equities are measured according to their price to earnings ratio, price to book value ratios and dividend yields. Bonds (fixed income) are primarily valued according to the inflation and interest rate outlook, while listed property is judged according to likely rental growth.
THE ROLE OF EXPERIENCE
“Lastly, to get a sensible mix of assets at the portfolio level, we also need to consider how asset classes are valued relative to one another. You can only buy more of an attractively valued asset class if you sell out of another. Similarly, if you want sell-out of an expensive asset class, you need somewhere to go.”
With all of these crucial points in mind, Odendaal says that an experienced asset management firm is best positioned to provide investors with the most suitable strategies to reach their return targets. “With the right asset mix, and clearly defined targets, your investment has the best chance of hitting its intended mark,” he concludes.