Economics & Markets

The four principles of dynamic asset allocation

By Nader Naeimi
Head of Dynamic Markets and Portfolio Manager - Multi Asset Group Sydney, Australia

Investors have profited from strong returns, backed by central bank liquidity and falling interest rates. But with rates seemingly at rock-bottom levels and global economic recovery maturing, returns could fall and markets could become more volatile. Investors may benefit from looking to use Dynamic Asset Allocation (DAA) to profit from shorter market cycles if they are to keep generating wealth.

Investors have enjoyed strong returns from markets in recent years, fuelled by Central Bank quantitative easing and record-low interest rates. Things have been so good and returns so smooth that many investors may have forgotten that financial markets are cyclical.

However, because we are now entering late cycle and rates are already so low, any change in interest rate direction could potentially challenge valuations and trigger greater market volatility.

If investors are to seize opportunities and generate wealth in this new environment, they will need to be flexible and adjust their portfolio to the market’s ebbs and flows.

We believe investors should increasingly turn to Dynamic Asset Allocation (DAA), a strategy that allows investors to regularly adjust their allocations to markets and asset classes based on what the market is doing and what they believe it is likely to do.

But how do investors implement DAA?

The principles of DAA

To successfully use DAA, investors must first understand the principles that underpin it. At AMP Capital we have engraved four key principles into our DAA investment process that will help any investor considering implementing such a strategy:

1. Risk is not the same as volatility

The first principle is that ‘volatility’ is not ‘risk’. Volatility is backward looking and measures an asset’s variability (how much its price moves around). Risk, however, is the potential to lose money and not recover. Investors using DAA should focus more on price ‘risk’ than on backward looking analysis like volatility.

2. Factor in investor expectations

Investors must also understand the critical role of investor expectations. High-performing companies with low volatility can have more downside risk than low-performing companies with high volatility. High-performance companies can find it increasingly hard to meet investors’ big expectations. When they disappoint, their shares fall. But low-performing companies’ expectations are typically lower and easier to beat. If they beat low expectations, their shares are can be strongly re-rated.

3. Diversification based on historical correlation is destructive

The third principle is that investors shouldn’t rely on historical correlations. Correlations can change, and they typically increase during economic instability. We often see high-priced popular investments become overcrowded. But when the economy turns, investors all decide to sell at the same time. Investors should consider diversifying based on asset valuations and how crowded a position is, rather than using historical correlations.

4. The market cycle leads the economic cycle

The final principle is that history has shown us that weak economic conditions don’t always lead to weak future share market returns. If you aim to buy assets when the economic cycle is strong and sell them when it’s weak, you may inevitably miss out on opportunities and be exposed to risks. It would, however, also be unreasonable to assume that the macroeconomics and earnings have an insignificant impact on future market returns. Indeed, a sustained and durable move higher in shares requires strong support from earnings growth and a healthy macro backdrop.

Cycles

DAA recognises that markets are driven by cycles. Those cycles range from multi-year ‘secular’ cycles to multi-month periods called ‘cyclical’ cycles. The secular cycle drives the primary trend in the share market; but the shorter cyclical cycles can also impact on investors’ financial goals. Secular cycles are driven by valuations; cyclical moves are driven by investor sentiment and central bank actions.

In the new market environment investors are facing now, it’s safe to assume the secular market cycle will deliver low returns. Shorter-term business cycles will therefore become critical, and to keep generating returns, investors should consider using DAA in attempting to lock in profits during upswings and protect returns during downswings.

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Nader Naeimi, Head of Dynamic Markets
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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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