As with sailing, setting the right course is crucial when investing. Once set though, adjusting the tiller in the face of changing financial tides is just as important.
For many of us, the warmer spells of the summer holidays meant finding solace near a cool body of water.
Perhaps you’re setting sail. As you set out on your nautical adventure, you will have to work with the winds to reach your destination. And its strength will determine how strongly, and in what direction, you must work to get there.
Setting the Course
Finding your destination on the charts is a precondition for a successful voyage. Similarly, investing is about understanding where you are financially and determining your financial goals before you cast off and put the portfolio together.
The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.
Research shows that having the wrong asset allocation poses a threat to long-term investment goals. Just as setting the course is more important than any one nudge of the tiller, core allocations should be set to suit the investor’s goals and risk profile. In theory, maintaining it should then be easy – rebalancing the portfolio weights automatically on a quarterly or annual basis.
However, this passive, mechanical approach doesn’t adjust for the continual changes in markets. In contrast, a dynamic and opportunistic approach can enable a portfolio manager to favour assets benefiting from tailwinds and withdraw from those facing headwinds.
Navigating the Currents
For example, in a trending market, like the equity rally in the first half of 2019, momentum tends to drive asset prices higher or lower for an extended period of time. In this environment, fixed rebalancing of a multi-asset portfolio without any discretion would see the portfolio sell the best performing assets and buy into the weakest; effectively cutting winners and adding to losers and resulting in a lower return than if you had left positions alone.
Equally, when the tide starts to turn on a trend like the equity rally, having the process – and the remit – to identify and sell over-valued assets (or buy under-valued assets) is advantageous. Active management of the allocation enables a manager to potentially enhance returns through the ups and downs of markets.
A recent example of this for us is where we anticipated a bounce back from the steep sell-off that occurred at the end of 2018 and tilted the portfolio towards growth assets. This served us well as easy monetary policy and positive developments in the US-China trade negotiations provided a favourable backdrop for risk assets: growth assets trended higher for most of the first half of 2019.
In early May, noting the strong performance of growth assets and concerned that investors were becoming complacent on relations between US and China, we reallocated some exposure from growth assets towards defensive ones. During May as a whole, global equities fell by six per cent, while developed market government bonds rallied 1.5 per cent. The chart below illustrates how we took advantage of the market trends that first drove growth assets to outperform, then reverse.
Dynamic opportunistic allocation decisions during 2019 market moves
Manning the ship
But reaping the benefits of flexibility to maintain the portfolio’s course requires having the right tools to make informed decisions and effective collaboration across teams. Ask your manager:
- How do they conduct their asset allocation? Is it dynamic or passive, in-house or outsourced, and why?
- What is their investment process? What resources do they use for their research?
- How do their teams work together to make investment decisions?
Being able to conduct proper research on the macro environment and spot emerging trends, as well as identify undervalued and overvalued assets across sectors, is paramount. Sharing this information efficiently across teams allows for debate and an alignment of views, ensuring investment choices in one part of the portfolio do not go against those in another asset class.
As the oft-quoted philosopher Heraclitus once said, “Everything flows and nothing stays”. So while setting the right course is crucial, maintaining it in the changing tides of financial markets also requires the right tools to navigate and effective teamwork to steer the ship.