The case for objective based investing in 2019
This paper argues that the inclusion of objective-based strategies, which explicitly recognise the importance of valuations in determining longer-term returns, can improve those portfolios which are less responsive to moves in market pricing due to the fixed strategic asset allocation (SAAs) approaches they employ.
This paper is an updated version of the paper ‘Avoiding the valuation traps in SAA’. It argues that the inclusion of objective-based strategies, which explicitly recognise the importance of valuations in determining longer-term returns, can improve those portfolios which are less responsive to moves in market pricing due to the fixed strategic asset allocation (SAAs) approaches they employ. We consider from first principles how objective based strategies should be treated in broader investment frameworks, including whether they possess growth and income asset class characteristics and consequently how such allocations should be funded.
• Portfolios built predominantly using a long run SAA driven approach can be subject to structural
inefficiency. The under-recognition of valuation information is the primary cause.
• Dynamic asset allocation (DAA) approaches are different in concept to objective based investment strategies as they remain anchored around an SAA. The argument that DAA is the same as objective based investment is therefore spurious.
• Resulting arguments that insufficient diversification benefits flow from objective based investments due to overlap with a DAA approach may also be spurious.
• The asset class distributions once allowing for explicit conditioning on (medium-term) valuations are fundamentally different to long-term capital market assumptions and therefore diversifying if used in broader SAA portfolio construction.
• Explicit use of valuation information over long periods of time carries efficiency gains in the form of lower volatility and/or higher probability of achieving real return objectives over reasonable time periods.
• Recognising that many asset owners are subject to (arguably increasing levels of) peer risk, we find objective based strategies have the ability to retain their merit in broader SAA driven investment
programs to provide:
- Reductions in downside risk capture;
- Increased efficiency in returns per unit of volatility; and
- Fundamentally driven diversification benefits.
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