Dynamic asset allocation as a risk control

Asset consultants and fund managers are vying for new ground in making asset allocation tilts on behalf of pension funds, with the rise of what is now generally referred to as ‘dynamic asset allocation’ (DAA). Greg Bright spoke with Georg Schuh (pictured), a managing director and CIO of Deutsche Asset Management in Frankfurt, about the trend.

For years pension funds have been, by and large, content to set their strategic asset allocation ranges based on traditional asset/liability modelling by their consultants. The ranges, therefore, tend not to change much.

But in the 1990s tactical asset allocation (TAA) overlays took off, particularly in some countries, as a means to both generate some additional alpha and control market risks. TAA services were generally provided by managers rather than consultants. In the past decade TAA’s popularity has tended to wane, however, but clever hedge fund managers have used many of these skills with their global macro funds. In the US, also, global balanced funds have managed to maintain a certain popularity, particularly, for some reason, with public sector funds.

Now, the middle ground between strategic and tactical asset allocation is being explored by both major asset consultants and some big managers – DAA.

Georg Schuh, a managing director and CIO of Deutsche Asset Management, says that the “big demand” for DAA-style overlays, at least in Europe, is coming from funds which are looking to protect their capital.

“It’s a bit like a more intelligent form of portfolio insurance, but we take into account volatility” he says. Portfolio insurance is a strategy which was used in the 1980s to continue to overweight an asset class as prices rise, as counterintuitive as this sounds. Many funds believe they were burned by the strategy in the 1987 stock market crash and it, too, fell out of favour.

Deutsche launched its DAA service in 2007 and it is one of a range of overlays from the manager which include interest rates, inflation and credit overlays. The firm has about 23 billion euro ($30.8 billion) in overlays.

“We developed the overlays over the past three years,” Schuh says, “but they’re built on the experience of managing the underlying investments for more than 20 years. We do a lot of TAA, which might have a horizon of one-to-two months or one-to-two years, which is the typical DAA horizon… It depends a lot on the client’s risk budget.”

For capital protection Deutsche automatically hedges through the use of futures.

“If hedging is not applied we can utilise our alpha skills,” Schuh says.

Given the market volatility of the past two years it is not surprising that DAA has struck a chord, whatever the strategy is called. The question for a fund which wants to embark on this path is who should make the decisions – fund staff or trustees, consultants or managers.

Both Mercer and Russell Investments have DAA services in most countries, with dedicated teams. Mercer says for a DAA program to be effective, the tilting decisions need to be supported by a strong and flexible governance framework within the client’s organisation. A manager will typically be used to implement the tilts through derivative overlays.

Deutsche is fairly bullish on global shares at the moment, as long as interest rates remain low.

“We have a strong view that we’ll see positive returns in 2010,” Schuh says. “I think we can get to double-digit returns for global equities, with emerging markets probably coming out on top.”

He says funds should remain overweight equities for as long as the central banks keep rates down.

“I think you should then go to neutral when rates start to rise,” he says.

However, the fixed income markets may be more difficult to predict.

“The bear market risk is increasing. I think that the ECB will hike rates by the end of the year.”

Schuh says the environment is such that there is more differentiation in rating sovereign bonds.

“One theme is that government bonds can become credit,” he says.