Market strategy

The bears have been caught on the wrong foot again. With the notable exception of Japan, the major stock markets have been hitting new all-time highs this month.

Concerns that the upturn in economic activity in the United States would lead to an increase in interest rates have so far proved to be unfounded.

In fact, the latest economic data has suggested some deceleration in the US growth rate which has reduced the pressure on the Federal Reserve to raise short-term interest rates – something it is usually reluctant to do ahead of the presidential race in any case. After the election, a rise of at least 0.25% is already reflected in US bond prices where yields have been going up steadily since January this year.

Avoiding surprises

Every pension fund trustee, investment director and committee member has a difficult decision to make: how to ensure that portfolios make the most of opportunities but also avoid the unexpected surprises caused, for example, by changes in economic policy; how to invest other people’s money in order to obtain the best return without taking undue risks. Should the portfolio be managed actively in an attempt to add value? What role does asset allocation play in the investment decision-making process?

The Efficient Market Hypothesis (EMH) first postulated in the 1960s has become the basis for the rapid growth of passive, or index-tracker, funds in recent years. In 1980, investment in passive US equity funds reached $7bn. By 1992, passive funds accounted for $432bn or about 30% of the equity holdings of all US tax-exempt financial institutions (Pensions & Investments, Crain Communications Inc).

In its strongest form, the EMH states that all available information has already been discounted in share prices. In this case, active portfolio management would be futile and all portfolios would eventually be indexed.

But experience suggests that although the stock market is highly efficient, it is not completely efficient. The hypothesis has, therefore, been generally accepted in its weak form which allows for the fact that some information is not discounted immediately. This leaves scope for both passive and active portfolio management. If all information was immediately discounted by the market price, active and passive management would become mutually exclusive.

The acceptance that the market is highly efficient but not completely efficient needs a major re-adjustment to the approach to the valuation of securities and markets. Traditional analysts and investment managers try to forecast the ‘correct’ value of security or market on the assumption that it is mispriced and ignore the information already factored into prices. An approach more likely to meet with success is to assume that the current market price reflects the combined judgement of investors and, therefore, provides the best estimate of relative value.

Once this assumption has been made, the investment strategist can design a portfolio that is diversified across different asset classes. The asset allocation will take into account the duration and currency of the liabilities the portfolio is designed to meet, and the tax position and risk profile of the client. For example, the degree of correlation between the returns on equities and risks in bonds and equities, in a combined portfolio, partially offset each other. The same applies to investing in overseas markets where the correlation between asset classes can give some guide to the mix that is suitable for a particular client and there are a number of software packages, known as optimisers, which are available to help this process. Nevertheless, the best investment strategies are based on forecasts of likely future returns, volatility and correlations, rather than extrapolated historic data.

Investment objectives

An important part of designing a suitable investment strategy is the initial definition of the client’s investment objectives and the setting of the investment guidelines. The investment objectives require the client to quantify its financial goals. The investment guidelines form the link between these goals and the investment management of the portfolio. If they are not properly formulated they can lead to misunderstandings in the future. The investment guidelines should also highlight the need for diversification and provide a benchmark. The benchmark will give a measure that will show whether active management through stock selection is adding or subtracting value, and whether the asset allocator is adding value or not.

For example, a suitable investment strategy for a marine mutual insurance company with a low-risk tolerance might be 70% in global bonds and 30% in US equities. This should produce higher investment returns with less volatility than a portfolio invested 100% in bonds (see chart below).

Once this policy is in place, the investment strategist can use active asset allocation to change the weighting of the portfolio around the benchmark.

To keep the risk within acceptable levels, active asset allocation should make small changes relative to the benchmark. Given complete certainty, the total portfolio would be invested in the asset class giving the highest return. In reality, the asset allocation needs to take into account the risk that forecasts will not be met. Changes in asset allocation are made infrequently to reflect the fact that major turning points in markets occur only three or four times a decade. For most of the time, the portfolio will be broadly invested in line with the benchmark.

The acceptance of the EMH in its weak form also enables strategists to concentrate on those factors not already in the price and are, therefore, likely to change market levels in the future. The main factors that drive share prices include the business outlook, as measured by the dividend growth rate; interest rates, which combine the risk-free rate plus a risk premium; and investors’ confidence, as measured by price-earnings or price-cashflow ratios.

These factors are used in simple quantitative models to indicate whether a particular market should be ‘overweighted’, ‘neutral’ or ‘underweighted’ relative to the benchmark and investment guidelines. These models have an enviable track record of highlighting when particular markets are overvalued or undervalued and, consequently, have enabled portfolios to be weighted to take full advantage of major turning points in the stock market cycle.

This is both in terms of being fully invested during bull markets and avoiding the worst of bear markets.

John Wright is chief executive of Global Portfolio Strategies.