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Fundamental changes

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Last year was exceptional for asset allocation. After a difficult start, from March, all risky assets offered outstanding returns and rose in an almost straight line. Interest rates remained very low and fiscal and monetary measures started to bear fruit.

Tactical asset allocation decisions added significant value for moderate additional risk. Much of this performance was achieved in credit – investment-grade and emerging debt – where the expected return in relation to risk was particularly attractive. Some equity exposure on the back of this proved a false dawn initially but momentum built from the second quarter. Currency management had a positive impact, with most of the performance coming from emerging currencies and a long position in sterling last spring.

It will probably be much more difficult to produce similar returns from tactical asset allocation decisions. The main asset classes will deliver lower returns and the path will not be as straightforward. As correlation between asset classes and between markets should decrease, investing in just any risky asset will not be enough to achieve performance.

Changes in fiscal and monetary policies will probably be the main factors driving differentiation. Lower correlations mean increased possibilities for relative bets within asset classes. This has already started in the bond universe. There may be some new opportunities in currencies asmonetary policies start diverging and emerging countries, especially in Asia, let currencies appreciate. Here again, specific fundamentals should drive performance.

The same principles should apply to security selection where decreasing intramarket correlation will favour the search for alpha and quality multi-managers should outperform equivalent singlemanager strategies.

However, the investment horizon for tactical asset allocation decisions may also be shorter as there is uncertainty with regard over the timing of changes to monetary policies. Investors would probably want to lock in profits as soon as they can. Riding the trend will not be thewinning strategy in the absence of any asset bubbles emerging. Lower correlation and greater differen tiation within and between markets can only be achieved in an environment of moderate volatility with no extreme tail events.

Paul Kim is senior portfolio manager at FundQuest

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