Choosing the right investment approach

Acknowledging that there is never a ‘one-size-fits-all’ strategy for investment, Tanya Debakhapouve explains how different investment approaches better lend themselves to different client circumstances. 

Asset allocation decisions, including strategic, tactical and dynamic asset allocation, are the key driver of investment returns.  Once the desired exposures to asset classes are established, the next level of decision making involves implementation of these exposures into the investor’s portfolio.  At both levels, the investment manager is guided by the investor’s investment objectives and goals, their risk tolerance, cost preference and time horizon, because the ultimate goal is to develop an investment approach that  addresses the investor’s needs.

The asset exposure implementation choices range from applying an indexed investment approach (which involves managing a set of funds to mimic a market index), an enhanced indexed approach (which combines elements of indexed and active management), factor-based strategies, and a fully active approach.  The latter can be delivered using a single manager or funds that include more than one active manager.  

Each individual asset class has its own unique characteristics (market dynamics, structural factors and cyclical considerations), which are more conducive to certain investment approaches and styles than to others.  Therefore, investments within each asset class need to be based on a clear investment strategy, which views these charactristics through the lens of the investor’s investment objectives and preferences to develop an approach that is best suited to their needs – that is unless the asset class is implemented using a indexed or an enhanced indexed approach.

What are factor-based strategies?

Factor-based strategies are generally used when the portfolio requires a certain investment style (such as buying ‘cheap’ stocks) to achieve its goal.  The strategies will invest in a large number of stocks that possess the required characteristics, and typically incorporate a set of portfolio construction rules to ‘manage out’ any unintended exposures.  The attraction is that they can be designed to suit an individual investor’s needs and, if well constructed, can offer a pattern of performance that is consistent with an actively managed fund but that is also more cost effective. 

When active management makes sense

Active management is suited to asset classes where markets are inefficient and active managers have proven to be able to add value.

As the finance theory goes, market inefficiencies can create opportunities for skilled active managers to generate returns in excess of the benchmark.

Here, an investor needs be cognisant of the fact certain types of active strategies and styles will be successful to a different degree depending on the prevailing market conditions.  For example, in markets that are subjected to substantial macro shocks, being good solely at stock selection may not be good enough.  

Thematic awareness, macro awareness and understanding the risk appetite dynamics would all be key to success under such conditions.  Some markets call for a more concentrated approach whereas some are more suited to broad diversification.  Finally, some markets may consistently work in favour of certain style characteristics.  

The role of the investment manager is to understand each individual asset class and its driving forces, as well as the nature of its underlying inefficiencies, and to create a favourable, yet diversified, mix of different managers/approaches that are well positioned, by design, to capitalise on the opportunities and to minimise any unrewarded risk.  

Further to this last point, mandates of active managers need to be structured in such a way as to grant them high levels of latitude in those areas where their expertiese is high; and limit their ability to make large bets in those areas where they have no strong capability.  For example, many stock pickers have suffered through the Global Financial Crisis because they failed to incorporate considerations such as currency and sector exposures within their investment decision making frameworks.

Factor-based solutions can be a useful ‘plug-in’ to balance out a portfolio’s style mix, to deliver a certain type of ‘beta’ or to manage costs at the portfolio level.  These can also be used to facilitate style rotation strategies although style timing is inherently risky and the requisite skill is rarely found amongst investors.

For those investors who use mainly strategic asset allocation

Diversified portfolios that have been built for investors with a long-time horizon, and that use predominantly strategic asset allocation, all else held equal, are generally suited to active management at the asset class level.  This is because actively managed strategies need to be given sufficient time to deliver their expected outcomes.  For these portfolios, performance will be driven by a combination of the long-term strategic asset allocation and also by the investment strategy, manager selection and portfolio construction decisions within asset classes.

When an indexed or enhanced indexed approach makes sense

In markets that are largely efficient

The more efficient the market, the more difficult it is for an active manager to earn returns in excess of the benchmark and the more suited these markets are to indexed and enhanced indexed strategies.

In portfolios that are particularly active in their asset allocation

If the investor has a shorter time horizon and/or is more active in managing their allocation across asset classes, they may choose to limit their use of active management within asset classes. A portfolio that incorporates a dynamic asset allocation (DAA) overlay on top of its strategic asset allocation is an example of such an approach.

Broadly speaking, the greater the reliance on dynamic asset allocation, the more sense it makes to use indexed or enhanced indexed approaches at the asset class level. Using active management to implement asset class exposures within a DAA-intensive investment framework may ‘interfere’ with the purity of implementing that asset allocation view.  As an additional consideration, the cost of trading active strategies to implement a DAA view may be higher than costs associated with using other strategies for this purpose.

To conclude, not all investors will make decisions based on the trade-off between risk and return. Many investors will require portfolios that help them achieve a certain goal whether that’s providing capital growth, delivering an income stream, preserving capital, or some other goal.  This type of investor may consider incorporating factor-based solutions that are designed to deliver a particular outcome, expressed as a metric like dividend yield, quality or high earnings growth.

Tanya Debakhapouve is head of public market solutions at AMP.