By Martyn Wild.
Testing times
The last time we wrote in mid-March 2020, markets were in the initial stages of reacting to the COVID-19 epidemic. At the end of that month, growth assets had been severely impacted and the broad Australian equity market fell nearly 21% in a single month. That's enough to shake the faith of even the most resolute investor. It is therefore understandable that the question gets asked, "what else can we do to protect our wealth?"
At MARQAM, we will always remind our clients to stick to their long term strategy as the most effective method of building wealth. Nevertheless, for those with an appetite to speculate by temporarily biasing the Strategic Asset Allocation toward or away from specific assets, there are options. We call ours Strategic Tilting (ST).
"Opportunities multiply as they are seized" - Sun Tzu
An SAA is a mechanism to build wealth by acting on derived estimates of the pattern of future long term market returns. The thing is, it isn't necessarily mutually exclusive from mechanisms that seek to capitalise on short term market movements; the two approaches can be used together and in our experience, can be complementary. However, there is a catch and that is that the error term for short term forecasting is much higher than for the long term. That means that we need to be very confident of the accuracy of a shorter-term signal. Our proprietary ST process builds upon the probability-based approach we use to construct the core SAA. However, in this instance, the focus is on positioning the portfolio to capitalise on short to medium-term opportunities.
In the chart below, we show the out-of-sample performance of our strategy that targets approximately 7% per year. Over the past 4 and-a-bit years, it would have delivered 7.1% per year on average. Nevertheless, like all market-based investments, it is not immune from market gyrations and it is those circumstances that ST is designed to address.
Growth of $100 - the core SAA
First, do no harm
By its very nature, ST acknowledges that the most consistent method to deliver long term wealth is via a properly constructed SAA. As such, ST has a comparatively high execution threshold, which generally translates into those occasions when markets are at valuation extremes - like now.
In the charts below, we have added a second line that illustrates the effect of adding ST to the core SAA. Our process will bias toward individual growth assets when they are deemed 'oversold' and vice versa. Looking at the results, there are several things to note when comparing the portfolio that includes ST to the one that doesn't:
The annualised return is appreciably higher - 8.5% per year v 7.1%
The volatility is largely unchanged - Approximately 4.2% per year
The drawdown profile is noticeably superior - lower troughs and quicker recoveries
Growth in $100
ST has added most value since September 2018 - this is no surprise as markets have become increasingly extended (in valuation terms) since then. ST only executes when markets are at extremes.
Drawdowns
One pleasant outcome from the application of ST is that in addition to increasing returns during market rallies, it reduces portfolio exposure to growth assets when they fall. As such, the drawdowns (when they inevitably come) tend to be less severe.
Annualised volatility
Over our sample period, the two portfolios have similar levels of annualised volatility (about 4.2% on average). However, you can see the effect of ST when it underweighted some growth assets in 2017/2018 and overweighted them as at the end of March 2020. Incidentally, our process remains overweight Australian equities and A-REITs (among others) as at the time of writing.
Jump at the chance
So if you are the kind of investor who is able to wait for opportunities to arise and pounce on them when they do, maybe you might consider some form of Strategic Tilting to make you a better hunter? It works for the tiger after all...
For more information or to talk to a member of the MARQAM team, please click here.
MARQAM is a privately-owned, boutique consulting company focused on providing superior investment outcomes for clients and greater profitability for businesses. We are not affiliated with any other financial institution
Disclaimer: The information provided here is for interest purposes only and does not constitute investment advice or a recommendation of any kind.
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