David Shairp, Head of Research at the Prudential Portfolio Management Group (PPMG), investigates the range of factors that multi- asset investors use to derive market insights and views that inform portfolio decisions. These would typically include valuation, macro factors, and behavioural or market timing factors.
Many investors usually separate strategic and tactical asset allocation decisions.
Why do we do Tactical Asset Allocation (TAA)?
Strategic Asset Allocation (SAA) looks at positioning the portfolio to benefit from medium to long-term views on capital markets, taking into account the secular views and associated regime changes as well as a broad high level perspective on the current cycle.
TAA complements this by shorter-term behavioural and market timing insights that look ahead one to 18 months. For example, positions may be taken to tactically overweight equities due to a positive view on the macro cycle, or to buy more equities due to a meaningful market sell-off.
Investment markets are constantly adjusting to new information, while investors’ risk appetite is also constantly changing. Asset prices are invariably more volatile than the underlying fundamentals and can often overshoot based on investor perception of new information, or where investor risk tolerance changes. Such volatility can create mispricings in asset classes which will be corrected by the market in time. Prudential Portfolio Management Group (PPMG) has designed its TAA process to identify shorter- term mispricing and medium-term price trends in asset classes that can be easily captured using liquid instruments over a typical TAA time horizon.
To illustrate this point, the chart below shows the significant drawdowns – and so a subset of TAA opportunities – that have occurred over the past 40 years in the major equity markets. History has shown that there have been about six to seven significant drawdowns per annum and that these have usually recovered over a typical TAA timeframe.
Traditionally, the best hunting grounds for TAA opportunities have been in listed equities, government bonds and currencies, all of which are highly liquid. Indeed, critical to TAA as a strategy, any position undertaken should be able to exit very quickly, without incurring material transactions or market impact costs.
PPMG’s Research Team
The Research Team supports the TAA process as well as other activities within PPMG, as shown in the diagram below. This ensures suitably informed investment views to support decision making, as well as consistent end-client communication to support Prudential UK business development needs.
PPMG’s TAA philosophy and process
Our over-riding TAA investment philosophy is to not take on a position unless we believe there is a significant mispricing or an enduring opportunity that has a high likelihood of being rewarded. Therefore we would typically have significantly fewer active positions on at any point in time compared to many global TAA or macro hedge funds.
PPMG’s research process has been created and developed to generate appropriate macro, valuation and behavioural insights to support the TAA investment philosophy as required.
The PPMG TAA process is designed to focus on three types of mispricing opportunities.
> Macro refers to developing investment insights relating to economic and market fundamentals such as economic growth cycles, inflation, long-term interest rates and corporate fundamentals
> Research Framework
> Valuation refers to developing investment insights relating to appropriate valuation parameters for various asset classes and sub-asset classes.
TAA decisions can be a combination of more than one element (i.e. they are not necessarily independent). For example, valuation may give context to a behavioural or a macro signal.
PPMG has created a robust, repeatable TAA process with a combination of qualitative and quantitative insights to support idea generation and robust decision making. The key elements of PPMG’s TAA process are:
> Research: monitor a broad coverage of markets and economies to develop and maintain investment insights
> Idea generation: identify outliers, and possible mispricing, using our three types of insight. Develop trade proposals.
> Decision making: evaluate trade rationale, sizing, exit conditions, risks and monitoring metrics.
> Implementation: allocate risk budget to trades, evaluates impact on overall portfolio risk, and the drivers of risk.
> Review: understands what’s worked and what hasn’t for the portfolio and specific trades; acts as a feedback loop to the research agenda.
TAA process overview
The evolution of TAA in the asset-management industry over the past 15 to 20 years has seen a growth in asset class coverage. At the time of the tech bubble in 2000, much TAA work centered round the stock/government bond decision. The early 2000’s brought a widening of opportunity sets, with regional equity and bond markets being added to the stocks/bonds/cash decision.
This grew further to take in individual equity markets, sector baskets and investment styles as well as FX strategies, comprising the G10 developed currencies as well as emerging markets, plus commodities. The PPMG TAA process covers all of the main equity, government bond, credit and currency markets, so very much reflects this.
The current environment of super-normal returns from risk assets, plus stretched valuations, suggests that future long-term investment returns are likely to be more subdued than in recent years. A less promising outlook for beta suggests there will be greater emphasis on generating alpha, which underpins PPMG’s decision to enhance the five key alpha drivers of PPMG’s investment performance outcomes:
> Mandate design
> Manager alpha
> Efficient portfolio management and implementation (including competitive fee levels).
We believe that a well-constructed TAA process can act as a complementary activity to PPMG’s other investment activities. Moreover, we believe that TAA as a strategy offers diversification benefits.
Find out more about the Prudential Portfolio Management Group