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The art of dynamic asset allocation

Global practice director of Towers Watson Investment, Carl Hess, explains why the consultant has conviction in the ability to exploit mispricing between asset classes, and when dynamic strategic asset allocation works.

There is no ideal asset allocation because resources – including in particular costs and knowledge – dictate that every fund’s position will be different.

But if Carl Hess, global practice director of Towers Watson, was starting with a blank slate, he would advocate about 10 different positions – from equities, to skill, to commodities – in the return-seeking assets.

“This is more diverse than anyone has been to date,” he says. “Good allocation has a lot to do with resources, internal and external, but if a fund is willing to raise the game, there are a lot of opportunities.”

Asset allocation will depend on the time horizon of the investor, Hess says, demonstrating that an endowment with a long horizon will be very different to a defined benefit that is risk-averse or is closing.

But he says probably the most important criteria affecting the appropriate asset allocation is resources.

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“Cost is one resource, knowledge is another. It is a competitive world, investors need flexibility, the speed to act, which is an organisational effectiveness issue,” he says.

Towers Watson has a model portfolio, where allocations are made according to the return drivers of underlying assets, and Hess believes it is a useful exercise for investors.

“We are looking at the return premium, insurance premium and illiquidity premium. We take an investment opportunity, have some measure of how to map that on to return drivers, then overall see how much of the portfolio is allocated. Qualitatively it is not very complicated, quantitatively it could be, but it’s a useful mapping exercise,” he says.

He is also an advocate of the somewhat opportunistic, dynamic strategic asset allocation which focuses on mid-term investment opportunities (three to five years), compared with strategic asset allocation (10 years) and tactical asset allocation (just months).

According to Towers Watson’s philosophy, DSAA can act as another source of risk and return in the portfolio. It says the primary focus of DSAA should be on adjusting risk exposure, it requires a broad opportunity set, and is broader than just asset class tilts, and requires a disciplined real-time decision-making process.

“The important thing is DSAA is pretty wide, but we are not making that many calls. We wait for evidence,” he says.

An example of DSAA, implemented by the consultant for a client in April 2008 albeit at a lower allocation, is a 20 per cent allocation to global investment grade credit, with the allocation coming equally from equities and bonds (the portfolio’s long-term allocation was a typical 70:30).

In April 2008 when the position was recommended, there was significant expansion in spreads on investment grade credit bonds, there was a widening in the gap between physical and derivative spreads and material liquidity premiums available.

In November 2009, when the position was taken off, the credit risk premium and the liquidity premium were both close to historical averages.

Towers Watson claims that the cumulative return for the portfolio with the tilt would have added almost 3 per cent to the portfolio between October 2008 and 2009, with the key focus on an adjustment of risk.

Generally, Hess who is based in New York, is disappointed with the level of innovation in the industry.

“Innovation in funds management is surprisingly low for the amount of brain power in the industry. It is cheaper to copy, 130:30 is the typical example – one person came out with it (and) now we have 300 products in that space and they can’t all be outperforming,” he says.

Towers Watson examines its own biases, in order to better understand them, and Hess acknowledges a bias towards boutiques.

“We have a bias in asset management people owning themselves but there is no one vowed business model. Generally we would like to see more innovation.”

As well as good, unique investment ideas, this could take the shape of the way business is conducted.

“We would like to see the fee issue as part of that, sharing the value created. How do you empower investors? They work through intermediaries, so can we advocate for our client base, buying power. I think there needs to be more co-operatives, investors banding together for better terms and co-investment, there needs to be better dialogue among the funds.”

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