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

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.

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.

For the long-only investor, the only genuine de-risking strategy is to reduce exposure to risk assets Hector Kilpatrick, Cornelian

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.

Another truism is that during the past two decades, central banks, when faced with falling asset prices, will do whatever it takes to arrest such declines.

Today, the major central banks around the world continue to corroborate this message. Therefore, one should not withdraw from the field altogether and, indeed, should look to start adding to risk positions when it is clear that central banks will have to step in.

This happened recently, when the Fed unambiguously announced a weak US dollar policy and the Chinese authorities massively increased debt issuance to help support financial asset prices and emerging market economic growth.

Hector Kilpatrick is chief investment officer at Cornelian Asset Managers