Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Why 2020 was tough for TAA despite volatility
Last year proved once again that market timing can be very profitable but an extremely difficult task to pull off, according to a new analysis of tactical asset allocation.
The paper, by influential Auckland-based actuarial advisory firm Melville Jessup Weaver and authored by newly minted actuary William Nelson, found NZ share investors could have engineered annual returns almost 35 per cent above the 2020 index performance of 13.9 per cent with a perfect tactical asset allocation (TAA) move last March.
By exiting NZ equities over March 10-23 – where the NZ market (along with global counterparts) suffered the biggest falls as COVID volatility struck – and reentering after, investors could’ve racked up an annual return of almost 50 per cent in the asset class, the MJW report shows.
“Should the move to exit equities be made too soon, the excess return is diminished. But moving ten days early still produces a return of 21.8 per cent, which is above the market,” the paper says.
“The impact of moving too late is more significant. An investor who exited the market just five days late will have a worse experience than the market return.”
However, a similar exercise carried out during a less extreme bout of volatility in October 2020 would’ve offered TAA market-timers much smaller potential rewards and a narrower window of opportunity to capture returns.
While the MJW study found last year was the most volatile period of the previous 16 years for NZ equities – edging out even the 2008 peak GFC turbulence – the above-average market gyration was concentrated mainly in March.
During March average daily volatility on the NZX hit 50 per cent compared to the long-term average of 10 per cent, the report shows. Aside from April and June, where daily volatility rose above 20 per cent, the rest of 2020 was relatively subdued for NZ shares, if a little above the long-term average.
But investors needed perfect timing to jump the volatility gaps, the MJW study says, with huge risks involved in even a three-day period out of the markets.
“The largest three-day gain occurred during the March rebound and accounted for 96 per cent of the total year’s return,” the paper says. “That is, missing out on these three days would have reduced one’s total return from 13.9 per cent to just 0.6 per cent.”
Investors looking to take advantage of TAA strategies could minimise the transition risk by dividing transactions into tranches or waiting for more subdued market conditions before executing: the former approach involved more “operational complexity” and cost, Nelson says in the report, while the latter offers only an “imperfect workaround” as volatility is unpredictable.
“The conclusion that can be drawn here is that while volatile markets create opportunities for significant market timing victories, these opportunities can be fleeting and investors must be nimble as well as decisive to fully capture them,” he says. “It is also worth noting that while approaches vary, TAA generally comes at additional cost to basic investment management services.”
This time is no different.
