You can’t tell the future, but you can practise your timing

This article is part of
Outsourcing – May 2016

You can’t tell the future, but you can practise your timing

Portfolio de-risking. The first question to address at the outset involves the investment philosophy.

Is it correct to try to time the market and alter a portfolio’s exposure to various asset classes as an investment cycle progresses, or is it more sensible to set an investment cycle agnostic strategic asset allocation and rebalance the portfolio periodically back to this predetermined framework?

The first approach allows for de-risking, the second does not.

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Your answer to this question goes straight to the heart of whether you believe active managers can add value to a portfolio over time, or whether a passive approach is more appropriate.

If you answered in the affirmative to the latter question, then read no further.

The skill in de-risking and, crucially, re-risking multi-asset portfolios is to understand that the pendulum of sentiment swings between fear and greed, and that, as a rule, means reversion of asset values does occur.

This means that asset values swing between being overpriced to underpriced and back again, and the skilled fund manager can try to stack the odds in favour of their investors when playing this cycle.

So when viewing equities, it is valid to ask how expensive a region is relative to history and to understand that if valuations are high then returns may be subdued.

Crucially, however, just because a market is expensive relative to history, does not mean that it is liable to collapse any time soon.

Assets can stay expensive and generate decent returns for a very long time before the mean reversion trade comes into play.

As none of us have the benefit of foresight, the timing of a de-risking exercise depends upon the interpretive skill of the fund manager and the balance of probabilities.

At the beginning of last year, it was becoming increasingly clear that equities were being priced for perfection. In other words, it had become received wisdom that the economic growth rate to ensure earnings upgrades would be forthcoming without stimulating a reaction from the US Federal Reserve in terms of putting up interest rates.

However, other indicators suggested that, far from seeing decent economic growth, the risks were actually to the downside.

Manufacturing inventories had ballooned and a de-stocking cycle would be required to rebalance inventories; and this – when linked to a slowing Chinese economy – would negatively impact commodity prices.

So, what to do?

For the long-only investor, the only genuine de-risking strategy is to reduce exposure to risk assets – equities, private equity, higher risk corporate debt – and keep the proceeds in either cash or short-dated government bonds.

However, value can be added by considering whether, in a risk-off environment, there will be a flow of money into perceived safe-haven assets such as the US dollar, US government debt, absolute return funds and gold. If so, the fund manager should position portfolios accordingly while waiting for the market turbulence to pass.