This Hong Kong manager’s needs are fairly unique and interesting. This firm offers a service whereby it selects and monitors individual outside managers to ensure they remain ranked among the top in their categories, or replaced when they do not do so. In addition to this service, the firm also offers an asset-allocation program with some fairly interesting characteristics. Largely due to the client base’s geographic location, the firm’s managers have tried to provide less U.S.-centric allocations than ones guided by market-capitalization weights. To this end, the firm’s strategy has been to reallocate some funds away from the U.S. and into other areas of the world, specifically the Pacific region.
Transaction costs, taxes, and other considerations have dictated that portfolio allocations be revisited only once a year, with exceptions made for extraordi-nary events. Finally, the firm’s portfolio revisions are designed to take advan-tage of a changing economic environment; a top-down approach is used to tilt portfolios toward perceived changes in the macro environment. The firm’s benchmark selection, along with the tilts in the annual revision of asset alloca-tions, generates a conservative portfolio, a balanced portfolio, and a growth portfolio. Clients can select from these based on their risk tolerances and preferences.
The firm’s allocations are based on the coming year’s economic outlook. (The outlooks, or forecasts, are similar to those the Wall Street Journal’s economist panel generated. Using the Journal’s forecasts, one can qualitatively surmise the asset-allocation tilts the firm’s model produces. These are discussed in Chapter 5, “Linking Up.”) Based on its forecasts’ historical variability, the Hong Kong firm develops probability estimates for the likelihood the different asset class-es will outperform each other. Table 8.2 displays sample allocations for each firm’s portfolios.
Table 8.2
Far East global manager’s conservative, balanced, and aggressive asset allocation: 2005.
Conservative Normal Aggressive
Asia Equities 8% 16% 20%
Asia T-Bonds 18% 6% 4%
Europe Equities 6% 11% 15%
Europe T-Bonds 20% 8% 6%
Emerging 5% 7% 10%
U.S.
Cash 6% 4% 2%
T-Bonds 21% 14% 7%
Growth 6% 15% 18%
Value 10% 19% 18%
100% 100% 100%
The Hong Kong firm has had some concern regarding the path of worldwide monetary and fiscal policies. But, despite these reservations, its global outlook has remained bullish. It currently believes a large upside for regions outside the U.S. remains a real possibility, although this forecast is less certain today than it has been in the past. As a result, the firm has come to view various world regions as equally attractive (more or less) in terms of the risk/reward tradeoffs. This view has resulted in an essentially equal allocation among the major world regions, with portfolios remaining less U.S.-centric than strict market-weighted portfolios.
In the firm’s conservative 2005 portfolio, Asia commanded 34 percent of allo-cations, a 16 percentage-point increase over 2004. A 26 percent allocation to European equities represented an 8 percent increase over 2004, although the allocation to emerging markets remained unchanged at 5 percent. The U.S.
allocation dropped to 35 percent, a 24 percentage-point decrease from 2004.
In the 2005 portfolio, the regional fixed-income portion was allocated in inverse proportion to the firm’s assessment of regional central banks sticking
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UNDERSTANDING ASSET ALLOCATIONto inflation targets. Europe led the way in this respect, with a 77 percent fixed-income allocation in the conservative portfolio. This allocation was virtually unchanged from 2004. Reflecting increased uncertainty regarding monetary policy and risk/reward tradeoffs, however, the firm reduced the fixed-income allocations for the portfolio’s two remaining regions: the U.S. and Asia. At 63 percent, the U.S. allocation came in 12 percentage points lower than it did in 2004, while Asia’s fixed-income allocation was reduced to 68 percent for 2005 from 82 percent in 2004.
The main change in the growth portfolio was a 14 percent increase in the emerging-market allocation at the remaining world regions’ expense. The equity allocation increased to 76 percent for Asia, 68 percent for the European region, and 62 percent for the U.S. For 2005, the Hong Kong firm viewed the various world regions pretty much as equally attractive in terms of the risk/reward tradeoff. An increased equity exposure is the way the firm moved along the expected returns and the risk/return tradeoff ’s volatility. There were two components to this. First, as the firm moved from the conservative port-folio to the growth portport-folio, it increased the equity exposure within each region without affecting the global allocation. Second, it increased the riskier assets’ exposure with the highest expected returns at the equity region’s expense with the lowest expected return. Increased uncertainty reduced the firm’s allocation to variables with the greatest expected returns. The greater-expected-returns dispersion forced the firm’s risk/return tradeoff to mute increases in equities and regional exposures for all the portfolios. This new allocation was aimed to protect the conservative portfolio against a downside and enabled the growth portfolio to increase its upside by taking into consid-eration the expected risk/return tradeoff.
The company’s global strategy performance is reported in Table 8.3. In addi-tion to the conservative, balanced, and growth portfolios, some reference port-folios—using the Morgan Stanley Capital Index (MSCI) as a proxy for global equity performance and the Merrill Lynch Global Broad Market Plus index as a proxy for global fixed-income performance—are reported as well. Using these two proxies, I constructed the following equity/fixed-income benchmark portfolios: 30/70 conservative, 60/40 balanced, and 70/30 growth. The results in Table 8.3 show the Hong Kong firm’s asset-allocation strategy fared quite well when compared to the reference portfolios over one- and two-year time horizons. The excess performance over the two-year horizon illustrates once again that CAA is a value-adding strategy.
Chapter 8 The Cyclical Asset Allocation Strategy’s Versatility
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UNDERSTANDING ASSET ALLOCATION Table 8.3Performance of the Far East global manager asset-allocation strategy.
2003 2004 2003–2004
Global Conservative Portfolio 18% 7.86% 28.14%
Global Balanced Portfolio 23.7% 9.39% 35.36%
Global Growth Portfolio 27% 10.67% 40.56%
Equity Benchmark
MSCI 30.81% 12.84% 47.61%
Fixed Income Benchmark
Global T-Bonds 5.1% 3.5% 8.78%
Fixed Income/Equity Combinations
30/70 Conservative 12.81% 6.3% 19.92%
60/40 Balanced 20.53% 9.1% 31.5%
70/30 Growth 23.1% 10.03% 35.45%
Source: Fund literature, MSCI, and Merrill Lynch