Adding Value through Dynamic Asset Allocation (DAA)

For most investors, a portfolio is not being held for a few months or even a few years. For the purpose of generating wealth and preserving buying power, most portfolios operate over a 5-10+year time horizon.

In such an environment, asset allocation is one of the most valuable tools to both generate return and manage risk. This is intuitive – a 30-year old executive is unlikely to hold a portfolio comprised entirely of bonds, and a 70-year old retiree would be ill-advised to have their entire portfolio in volatile equity exposures.

Each asset class has a broad risk and return profile, and when operating over multi-year time horizons, the interplay between these profiles is key to a superior outcome. But are there ways to generate even better outcomes through actively managing your asset allocation?

The Benefits of Being Dynamic

Dynamic Asset Allocation (DAA), involves actively managing the asset allocation of a portfolio based on top-down/broad asset views of markets. This might involve tilting a portfolio away from equities to bonds, or being underweight real estate in favour of cash – based on a deviation from some long-term fair value, enhanced macro risks, or a structural factor which changes the investing landscape in the short-term.

We also consider allocating between different factors within asset classes (such as Value vs Growth in equities) to be part of the DAA process, even though you might not classify them as rotating ‘asset classes’ specifically.

DAA tends to look over a 1-3 year time horizon and adjust a portfolio to cater for the near-term risks and opportunities of a market. This does not mean that DAA completely ignores Strategic Asset Allocation (SAA), which tends to be a 10+ year view – rather, it can be viewed as an enhancement to safely steer a portfolio through market cycles.

Indulge the analogy of a sailboat on its way from Sydney to San Francisco.

SAA says roughly when and where the boat will arrive, and if it will make the journey at all. DAA is what helps the captain avoid one area which has a storm brewing, avoid the sharp rocks which are likely to be there at a certain point in the tide – it’s SAA which is ultimately guiding the journey, DAA just helps you get there without a leaky hull and a bad case of sea sickness.

What goes into DAA?

Like most portfolio management techniques, the implementation of DAA spans a spectrum from intuition and simple strategies, to complex mathematical and factor frameworks.

In general, there are a few key tenants to DAA that advisors and individual investors can consider:

• Valuation: are equities at an extreme P/E, are bond yields at 1%, is property yielding you less than a corporate bond etc?
  
• Macro: are central banks aggressively tightening rates, are governments injecting stimulus into the economy, has a war made investors flock to gold etc?
  
• Economic Fundamentals: are we likely heading for a recession or is growth slowing, is inflation rapidly accelerating/decelerating?
  
• Correlations: are rates going up, and the portfolio happens to be exposed to multiple ‘diversified’ investments which all happen to be interest rate sensitive?
  

You can of course extend these inputs further. For example, a robust DAA process might consider forward-looking return forecasts for different assets or even factors.

When looking at the chart below, a DAA process might use the higher expected return over credit and government bonds to tilt away from equities:

Or even within risk assets, a DAA process might tilt the portfolio away from developed market equities and into Emerging Markets (often its own separate asset class bucket) based on forecasts like the ones below:

An investor might add as many layers of sophisticated to this process as they understand and can effectively implement, but the key takeaway is that there are many intuitive and actionable inputs which can help inform a DAA process for a portfolio.

Case Study - Conservative Client Portfolio

As a case study, let’s relate implementing DAA to the context of a conservative portfolio for a pension client.

Suffice to say, those maintaining a 30/70 static allocation throughout 2022 saw some of the worst client outcomes in recent investing memory – simply playing out a collapse in any asset with interest-rate sensitivity is not a strategy managers should entertain, particularly when clients have sequencing risk and may very well need to access their funds during this period of market downturn.

What if an adviser or manager had implemented a simple, easy to execute DAA framework:

• Taking a one-year view, rotate clients slightly out of equities, towards fixed income and cash
• Within equities, tilt towards less duration-sensitive allocations, such as Value
• Within fixed income, tilt towards less duration-sensitive allocations, such as floating rate corporate bonds

We show the attribution of such an example portfolio below, compared to a benchmark-standard multi-asset SAA for a conservative fund.

By implementing a simple, intuitive DAA framework, a client would have had a materially better outcome over most time periods – over 1% on a 1-year basis. [Remember, this is not your typical manager selection, this is allocating to specific factor-exposures within the same asset class, rather than necessarily choosing Global Manager A over Global Manager B based on their 3 year track record.]

Of course, by letting this example allocation run without changing anything you might be behind in the recent tech rally, but in times of extreme market stress, DAA more than justified the exercise in this case study.

Try DAA Today

Investors of all sizes and sophistication employ DAA to enhance portfolio returns, better navigate risk and produce a better client outcome over the long run.

For multi-asset investors like Innova, DAA is an essential tool in ensuring a smooth return profile for clients, a key pillar of active management which ensures an evidence-based approach to investing rather than chasing trends or risky market moves.

For any investor, having a long-term view of their portfolio allocation, with some nimbleness and dynamism to account for the ebbs and flows of market cycles, is a worthy use of focus and time.