Wednesday, 01 June 2016 - 20:00

 

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Seed Weekly - Tactical Asset Allocation ? Enhancing your Experience

My last article was on how our funds/portfolios are structured with different Strategic Asset Allocations (SAAs) for investors with different investment horizons and risk appetites. This week I’ll take a closer look at Tactical Asset Allocation (TAA), i.e. how we adjust the asset allocation away from the SAA in order to improve the fund’s risk/return profile.

While we are comfortable that a fund’s SAA should generate sufficient returns over its recommended time horizon, our research indicates that by systematically applying a valuation based tactical overlay the investment experience (either through reduced risk or increased returns – or both) can be enhanced.

Practically speaking, we believe in mean reversion. This is where cheap and expensive assets will both revert to fair value over time. We therefore look to systematically increase our allocation to cheap assets, while at the same time we reduce our allocation to expensive assets.

For the purposes of this article I’ll show a couple examples of how our valuation models have filtered into the positioning of the Seed Balanced Fund. Firstly, when looking at the allocation to local equities, as Cor showed in his May article, local markets are currently as expensive as they have been for at least the past thirty years. The chart below shows the local market’s valuation at the end of April 2016 (for a refresher on how to read the chart please click through the link above to Cor’s article). Based on this valuation, the allocation to local equities is hovering near the fund’s all-time lows (35% at the end of April versus SAA of 50%). We expect substandard returns from the local equity market and have therefore reduced our exposure to this asset class.

Four years ago the picture was different. The chart below shows the local market’s valuation in April 2012. At this juncture, the fund was slightly overweight to local equities (53% vs SAA of 50%) as the market was offering slightly better value than its long term history suggested. Over the intervening four years we have been gradually reducing the fund’s exposure to local equity as the market became ever more expensive.

The other asset class that is currently at extreme levels when using our valuation techniques is our currency (the Rand). With all the weakness that has been experienced by the Rand in the last few years it is easy to think that it has always been a one way bet, but this is not the case.

At the end of 2010, the Rand had strengthened by more than 50% over the previous two years. From the end of the Global Financial Crisis (GFC) in 2008 the Rand strengthened from over R10/$ to R6.60/$. Investors (particularly those who had taken their money offshore in the panic of 2001) did not want to hear about investing offshore. Remember, this was just after our successful hosting of the football world cup and emerging markets (especially BRICS) were also the flavour of the month in the investment world. The chart below shows the ZAR vs USD and our best estimate of fair value (PPP) at the end of 2010.

It was at the end of 2010 that the Seed Balanced Fund’s allocation to global assets was moved to its maximum mandate limit, and this allocation has been broadly maintained (to much success) over the past 5 years. With the currency blow out in December 2015, and subsequent weakness, the Rand is now trading at levels (vs PPP) rarely seen – the chart below shows the extreme weakness witnessed over the past 5 years.

We continue to favour global assets over local assets, and have therefore retained our global allocation at its mandate limit (25% + 5% Africa) but since the beginning of the year, in a series of transactions, we have implemented zero cost structures that protect half of the global assets from any currency strength, while at the same time allowing the Fund to profit from any weakness up to around R19.50/$.

While we don’t have a crystal ball that will tell us what the return of the ALSI will be in 2016 or where the Rand will end the year vs the US dollar, our research indicates that there’s a good probability that investors in the local market will be disappointed over the next 5 years, and that we shouldn’t be surprised if the Rand strengthens going forward. We have therefore positioned our portfolios in such a way that they are able to capture these expected moves.

Since the launch of the Seed Balanced Fund in 2010 our TAA decisions have consistently added value (both by reducing risk and enhancing returns) and as we develop our TAA process further we expect this to continue.

Kind regards,

Mike Browne

Tel +27 21 914 4966
Fax +27 21 914 4912
Email info@seedinvestments.co.za

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Wed, 01 Jun 2016

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