The investment horizon affects asset allocation preferences. The strategic allocation should be made in accordance with the investment horizon and the features and development of the balance sheet – that is, an understanding of liabilities now and in the future.
Asset allocation decisions can focus on selection of asset class, country, currency and sector. However, security selection should not be the dominant part of value added. The selection of asset class is more important than the selection of individual securities for longer investment horizons.
Furthermore, it is important to stress that a predetermined static allocation of assets between different asset classes is insufficient, in order to achieve highest possible outcome. Value is primarily added from the ability to actively reallocate the assets and thereby achieving a significant excess return.
In active asset allocation the objective can be to achieve a return no less than a medium risk equity benchmark on the predefined market, at substantially lower risk. The objective is obtained through an active reallocation between the different asset classes, equities, bonds and cash. The mandates may be implemented either as a overlay portfolios or as a portfolio of physical securities which is what we practised.
Normally the business cycle lasts for five years. In addition, the average du-ration for countries’ outstanding public debt in fixed income securities amounts to five years. Therefore five years should be regarded as a normal investment horizon. From a Swedish investor’s view, a global asset allocation portfolio with a five-year investment horizon, a benchmark of one third Swedish equities, one third glo-bal equities, one sixth Swedish bonds, one sixth Swedish bills is recommend-ed. With longer investment horizons the equity weight should be greater.
To set asset allocation and arrive at optimal allocations for different asset classes and regions/markets, several methods are used. Our investment process may be described as a funnel. The top part consists of a broad topical area and forms a platform from which rough calculations are made. By gradually going down the funnel, the peripheral factors are screened out and the focus is set on asset classes and securities, which finally end up in a portfolio selection and optimisation. Most important are the results and correlations from the top-down analysis, the theme analysis and the bottom-up analysis.
The first step in the investment process is a top-down analysis consisting of qualitative assessments in a model, which is constructed on the various historical data. This part of the process strives to forecast the primary turning-points for the equity and fixed-income markets, and is reflected by various tactical turning-point indices in what is known as a top-down analysis.
By developing investment themes, TUIM is enabled to assess how the industry and the company is positioned and affected by the investment themes. The focus is on finding the factors driving the changes as well as identifying which industries and companies possibly benefit from these. We penetrate a number of themes simultaneously, identifying positive as well as negative themes and trends.
The bottom-up analysis is the third step, consisting of a market assessment of the equity market. The analysis is comprehensive and involves a consideration of the value the market subscribes to a stock.
To determine the weights between the various asset classes, calculated on the above variables, the probability of each individual asset class’ potential to outperform (risk-adjusted), the other competing asset classes is computed. These probabilities change and are adjusted continuously. Three different probability assessments are made: probability that equities will outperform cash; probability that equities will outperform bonds; probability that bonds will outperform cash.
Since the return on different asset classes can fluctuate heavily, it is crucial for the performance that the different asset classes’ weightings in the total portfolio can be changed dynamically. The portfolio must not, as a consequence, be so narrowly defined that it resembles a static asset allocation. Changes in each asset class’ share of the total portfolio are carried out approximately two to four times each month. Through continuous changes in weightings, at the same time benefiting from the most favourable asset class, market-timing outperformance is created. We put a lot of effort into the dynamic aspect of asset management, for example, to allocate more assets to the ‘right’ asset class from time to time.
Lars Källholm is managing director, at Trevise Unibank Investment Management in Stockholm