Back to basics
Tactical asset allocation can successfully navigate a changing investment landscape by remaining faithful to a well thought out investment process.
On a monthly basis ASI publishes its multi-asset TAA investment views at the front of this publication. In this article we discuss the process behind defining our asset class views.
Studies suggest that a group is smartest when each person thinks and acts independently.
Tactical asset allocation (TAA) is an active investment approach, which focuses on asset class and currency allocation across four key groups (stocks, bonds, real estate and cash) within a multi-asset portfolio. It typically operates over a rolling one-year time horizon. The aim is to take advantage of excessive reaction by investors to economic, corporate and geopolitical events in different countries by expressing overweight and underweight investment positions relative to clients’ long-term strategic benchmark allocations.
There are times when this challenge appears to be a relatively straightforward task: the world makes sense, fundamentals play out as expected and market behaviour appears consistent. There are other occasions when the opposite is true and uncertainty reigns: it can be difficult to make sense of a changing world. An obvious example would be the recent ‘weaponisation’ of trade policy by the United States, at a time when the global economic cycle is relatively long in the tooth – making it increasingly difficult to make confident predictions about key drivers of economic, corporate and therefore market performance. In the absence of a ‘true north’, individual market participants struggle to hold views with conviction, investment time horizons shorten and emotion begins to cloud judgement.
How does ASI’s TAA team navigate a changing investment landscape? The answer is by remaining faithful to a long-standing and well-thought out investment process. This is no easy task: fund managers are human beings, and human beings are far from perfect. We all have biases and we all make mistakes. Our job is made harder by the sheer volume of information at our disposal to digest and analyse. Some critics would argue that the task is more complicated when investment decisions are made by a committee rather than an individual! However, there is a greater likelihood of success if the task is approached in a structured way.
James Surowiecki’s book Wisdom, of the Crowds, is essential reading for anyone involved in group decision making. Supported by numerous academic studies, the case is convincingly made that “the many are smarter than the few” - but only when certain conditions are met. For the crowd to be smart there must be diversity of cognitive thought and opinion, independence of belief, decentralisation and a mechanism to aggregate judgements into a collective decision. We examine each of these important issues in turn.
A successful team should comprise individuals with different skills, career paths, specialisation, length of experience, and analytical preferences, to list the most obvious examples of cognitive diversity (not to mention other manifestations of diversity such as gender, nationality and culture). In other words, a new member of a team should preferable bring new skills to bear. A diverse team benefits from broader perspective, is better at keeping or retaining its knowledge, learning from experience and is more likely to make decisions based on facts rather than authority or influence. Such an environment encourages individuals to share what they really think. An additional result is a greater level of disagreement amongst team members than might otherwise be the case, but this is exactly what is necessary to guard against ‘groupthink’. Psychology Today explains that ‘groupthink’ occurs “when a group of well-intentioned people make irrational or non-optimal decision that are spurred by the urge to conform or the discouragement of dissent”.
Studies suggest that such a group is (paradoxically) smartest when each person thinks and acts as independently as possible. In other words an individual’s opinion should not be determined by the opinions of others. Independence makes the group smarter because it is more likely to uncover new information and reduce the risk of a collective error. In theory individual errors should cancel out, although this may be a controversial assumption! However, such an outcome is hard to achieve because humans are sociable and it is common practice to learn from or even imitate others. If a colleague is undecided, there is social pressure to follow the majority view. That might be a sensible outcome but not at the expense of doing the necessary homework. Unquestioning imitation will make the team less wise. The responsibility of each team member, therefore, continuously to develop their own ‘private’ library of information (i.e. data, research, interpretation, analysis, intuition) cannot be understated. If at the end of the day a colleague is still consciously unwilling to express a view in favour or against a market that is quite satisfactory. On many occasions a market position could justifiably be neutral.
Providing team members the autonomy to focus their interest and energy on certain markets and/or analytical approaches encourages specialisation, which in turn fosters decentralisation. This makes individuals more effective (productive and efficient) and increases the breadth and diversity of information available to the team. For example at ASI the TAA team conducts its own markets research, and also collaborates with asset class (equity, fixed interest, and real estate) plus economic and political experts, both internal and from external sources to find insights. A risk is that information uncovered by one colleague or team need not be shared or understood by others. The solution is the development of a ‘common language’ to help facilitate the aggregation of the team’s insights. In our case we organise our thoughts and deliberate around four factors: macro-profits, monetary, valuation and behavioural drivers, with a ‘focus on change’ approach.
While all three of the previous conditions may be present, without a way to turn individuals’ private information into a collective decision, a group’s efforts may be wasted or fall short of potential. Aggregation requires a straightforward process. In our case, individual team members numerically score each market driver, as well as provide an overall consolidated score. Importantly it is a secret ballot which goes a long way towards eliminating some of the pitfalls of collective decision making. The reasons behind any individual’s views on the market factor scores can easily be identified for further discussion. The next part of the process ranks the scores to work out which markets are most liked and disliked, to show which assets have been upgraded or downgraded and to identify areas and indeed the extent of the group’s agreement or disagreement. This approach also provides an effective learning loop: good and bad views can be analysed both at the individual and team level, with the aim of making better decisions in the future. It also helps guard against the risk of team ‘polarisation’, where in certain circumstances discussion produces a more extreme view.
There is of course the important question of how much discussion should take place before an investment decision is made, as well as what should be discussed, who should speak and for how long? These are valuable process questions because in any group individuals inevitably exert direct and immediate influence on others. The danger is that judgements become more volatile and extreme. In order to avoid sub-optimal outcomes, we follow a number of vital processes:
- meetings must have a set agenda giving everyone the opportunity to speak;
- evidence is examined before reaching a conclusion, especially information that runs contrary to a perceived view;
- the team is not obliged to reach a consensus. A minority view makes decision making more rigorous, even if the minority view in question turns out to be wrong.
Current Asset Class preferences
What is the outcome of these deliberations, in terms of asset class preferences, in past few months? Table 1 presents the team’s average market factor and consolidated scores expressed on a scale of -3 to +3. It should be noted that the consolidated score is not a simple average of the driver scores. Also shown are the percentages of the positive/negative votes, as well as the net position in favour of each asset class.
- Equities are preferred with a positive score, a large majority in favour and no dissenting minority view. A positive monetary and macro-profit driver mainly explains this. Put another way, easier central bank policy making offsets recession risks.
- Credit is next most attractive, followed by real estate and government bonds. The valuation factor clearly drives the dislike of government debt, although the behavioural driver (very overweight investor positions) is also a negative.
Table 1: Consolidated market factor scoresSource: Aberdeen Standard Investments (as of August 2019)
Given the volatile equity market performance, our outlook for this asset class is worth exploring further. With respect to the macro-profits driver, leading indicators of economic activity point to a modest recovery in industrial production over the next 12 months, which in turn, suggest modest single digit corporate profit growth in most regional blocs. This is best illustrated by the stabilisation and modest recovery of our macro-momentum indicator, albeit still low by historic standards (chart 1). Based on past experience, equity market returns are on average mildly negative and volatility above average when macro-momentum sits below 45%. However, our monetary conditions indicators suggest a further improvement in macro-momentum over the next 6-12 months. At the same time the future path of the US-China trade war remains open to debate with little visibility and its impact is also hard to quantify with precision – as a result the level of conviction attached to leading indicators is somewhat muted. Nonetheless, macro-economic news has consistently, and negatively, surprised investors. Ironically, this means that the sensitivity of the stock market to good news could be greater given the weaker investors’ growth expectation.
TAA Chart 1: Losing negative momentumSource: Aberdeen Standard Investments (as of July 2019)
Major central banks have acknowledged that monetary policy must be used to support economic growth, triggering a reassessment of the path of interest rates by government bond market participants. This expectation has so far calmed investors and reduced, but not eliminated, its sensitivity to bad news. We do not currently consider equities to be expensive on the condition that the global economy avoids a recession, but markets are unlikely to re-rate significantly. Bond yields have already fallen substantially and the risks around profit growth are to the downside in the short term.
What is clear is that the exuberance towards equities apparent 18 months ago has melted away and been replaced by an air of considerable caution. Whilst we cannot be measure investors’ fear and greed directly, there are ways to do so indirectly: looking at a combination of financial market sentiment measures, as well as surveys of investor sentiment and positioning. Nowhere is this better illustrated than by our equity market short-term timing indicator, which has fallen considerably and currently sits well inside the ‘buy’ zone (chart 2).
TAA Chart 2: The right time to buy equities?Source: Aberdeen Standard Investments, Refinitiv Datastream (as of 23 August 2019)
Cautious Optimism: moderately overweight risk with diversification
Going back to our four drivers of group decision making (diversity, independence, decentralisation and aggregation) the current collective view is one of cautious optimism towards equities, and so is consistent with a moderate overweight towards the asset class, within a multi-asset portfolio. We note that as geopolitical news may lead to sharp swings in sentiment, flows and prices, these may well provide opportunities to add incremental positions in portfolios by tactically adjusting equity market exposure sequentially higher and lower. At the same time, given the risks of a policy error, it is important that a portfolio holds some diversifying investments if the central case is proven wrong. In our TAA portfolios we do so via an overweight position in the Japanese Yen against the Euro but a variety of other approaches (Swiss Francs, Gold, derivatives) could be adopted depending on the appropriateness for each client’s portfolio.
Studies suggest that a group is smartest when each person thinks and acts independently.