Strategic Asset Allocation Value Equities Value Bonds Fixed Income Strategy Strategic Asset Allocation The Academic Background Strategic asset allocation has a strong academic pedigree and, in making this strategy the foundation for its investment style, Sparinvest acknowledges a debt to all of the great thinkers who have helped to shape and hone the theory behind this method of investing over the last sixty years. Key amongst them are: Harry Markowitz The American academic Harry Markowitz first invented his Modern Portfolio Theory in the 1950 s. He began by looking at the beneficial effects of asset diversification as a means of reducing risk within a portfolio. Taking his observations a stage further, he discovered that by blending together non-correlated assets (that would perform entirely differently in different economic conditions); he could optimise the potential of a portfolio. Markowitz developed the idea of an efficient frontier for investment. This was the point at which an optimal portfolio was reached and no asset could be added or removed that would improve its performance. In 1990, Markowitz was awarded a Nobel Prize for his contribution to investment science. William Sharpe A student of Harry Markowitz, Sharpe s studies further developed Markowitz Portfolio Theory. Sharpe invented the Capital Asset Pricing Model (CAPM), a pricing theory which helps measure a portfolio s systematic risk (beta) and the compensation or returns an investor can expect from it. Sharpe was awarded the Nobel Prize alongside Markowitz in 1990. Fama & French Eugene Fama and Kenneth French, jointly extended Sharpe s CAPM into a three-factor model. Fama and French plotted the returns from the US Stock Market for the three decades from 1964 to 1995 on a model that categorized stocks by their size and priceto-book characteristics. The results demonstrated that, above and beyond a stock s beta, size and value were two further factors that could have a positive impact on investment returns. Eugene Fama s 1960 s PhD dissertation also gave rise to the hugely influential Efficient Market Hypothesis which states that at any given time, security prices fully reflect all information available to market participants. Therefore, if a market is efficient, no individual investor should expect to be able to outperform an appropriate benchmark of that market on a sustained basis. In the late 20 th /early 21 st century, numerous academics, including Fama & French, began to consider the momentum factor. The momentum effect was first described by Jegadeesh and Titman in a paper published in 1993. They found that recent returns give an indication of future returns. Academics studying momentum have also noticed an effect called short-term reversal whereby a high past-month return is likely to be followed by a poor return for the following month and vice-versa. Sparinvest I Strategic Asset Allocation Strategy Page 1
Michael C Jensen whose 1968 paper, The Performance of Mutual Funds in the Period 1945-64, was the first major study of fund manager performance. It concluded that no mutual fund manager was able to use timing abilities to add value over the long term. Benjamin Graham In addition, we are mindful of the human factor that affects all investments as described in the following quotation from Benjamin Graham: The Investor s chief problem and even his worst enemy is likely to be himself. What is Strategic Asset Allocation? Asset allocation is the process of dividing a portfolio among the major asset classes such as bonds, stocks or cash in order to reduce risk and optimise long-term returns through diversification. The starting point for the process is the investor s risk tolerance level. This not only determines the asset allocation goal for the portfolio at inception but also on an ongoing basis. The ultimate goal is to deliver to the investor an optimal portfolio offering the highest possible return for the lowest risk. The skill of the strategic asset allocator lies in blending instruments that have contrasting behaviour patterns in different economic conditions. Thus each asset is chosen for the beneficial effect that it will have on the portfolio as a whole either because it has the capacity to boost returns or else because its presence in the portfolio will help to neutralize the risks associated with other investments held. Because the value of assets can change depending on market conditions, the portfolio needs to be rebalanced periodically to maintain the right balance of assets for the agreed risk profile. Why is it so Important to Allocate Strategically? Assets can be allocated to a portfolio in one of three ways: Tactically speculation to take advantage of short-term market movements; By stock picking selecting individual securities on their own merits; or Strategically choosing assets of a certain type for their capacity to interact with other portfolio holdings to create a beneficial effect on the whole. Unlike market timing, or the prospects for individual stocks, strategic asset allocation is the only factor affecting investments that can actually be managed successfully over the longer term. It is also by far the most important, as shown by the figure below. Sparinvest Strategic Asset Allocation Strategy Page 2
100% 80% 91.5% 60% 40% 20% 0% Strategic asset allocation 4.6% Stock-picking 1.8% Tactical asset allocation (timing) The impact of asset allocation on return variation. Based on a study by Brinson, Hood & Beebower of 91 large USbased pension funds from 1973 to 1986, updated in 1991. A related study undertaken by Sparinvest and based on all Returns Based Style Analysis on European based equity funds delivered similar results. How is it Possible to Manage Risk? The investor is wise who diversifies. Wars, coups d état, interest-rate movements and recession all represent sources of unavoidable, systematic risk to securities markets. They can affect a broad range of securities if not the entire market and can only be avoided by being out of the system or mitigated by hedging. But, whilst every stock-market investment carries a risk of loss of capital, diversification helps to disperse and reduce the non-systematic risks involved with investment in individual shares simply by adding other shares to the portfolio. Thus if one company announces a drop in profits, the short-term negative effect on its share price is neutralised within the portfolio by the performance of the remaining, unaffected investments. Company Risk Sector Risk Country Risk But we can t eliminate all investment risk To reduce the risk of investing in a single sector, we invest in other sectors. To reduce the risk of investing in a single country, we invest in other countries. The remaining market risk will be what decides the risk and return attributes of the portfolio. To reduce the risk of investing in a single company, we invest in more companies. Strategically Constructed Portfolios Portfolios must be constructed strategically, using knowledge of asset correlations and volatility. The figure below shows how the dynamic effect of holding two different asset types that are not affected by the same economic factors and that behave as independently of each other as possible is to drag down their combined risk, but leave their performance prospects unimpaired. Sparinvest Strategic Asset Allocation Strategy Page 3
Expected return 2 Equities 1 Blending together assets with a low correlation to each other can either reduce portfolio risk (1) or improve expected returns (2) Bonds Volatility (the main cause of loss of capital) Replicating such dynamics throughout the portfolio will achieve the highest return at the lowest risk, an investment goal known as the efficient frontier. An optimal portfolio is one that sits on the efficient frontier. In other words, its composition cannot be improved. The Fama/French Factors As a strategic asset allocator, it is impossible to ignore the research findings of the academics, Eugene Fama and Kenneth French. Their famous study on the returns from the US stock market, published in 1996, investigated the style factor and concluded that investors were likely to be better compensated for risk if their investment portfolios were skewed towards those companies occupying the value and the small-cap sectors of the market. Fama & French subsequently researched international market data and found the same effect. A Study of Excess Returns US Market 1963-2006 -5.9% Small Cap 4.5% 9.0% 7.2% -2.2% 3.4% -0.2% Growth 5.2% Value -1.1% Large Cap 1.8% Based on Value-weighted data for US market over a period of 40 years, the matrix shows the results of an annual division of the universe into 25 portfolios based on style exposure. Thus each portfolio is ranked according to the size and price-to-book-ratios of the companies that it theoretically invests in. Data source: Kenneth French CRSP database. Calculations: Sparinvest Academic study has added a further dimension (risk factor) to the familiar Fama French matrix namely momentum. Sparinvest Strategic Asset Allocation Strategy Page 4
In order to create optimal portfolios, therefore, it is important to consider not just the allocation between asset types but also the way in which the style factors such as size and price-to-book and momentum can impact upon performance. The Sparinvest Approach to Strategic Asset Allocation Strategic asset allocation has become fashionable within the investment industry. This is hardly surprising when the academic evidence in its favour is so convincing. However, strategic asset allocation is a rigorous and often counterintuitive discipline. Very few asset managers find that they are able to subscribe to it completely because the temptation to believe that they can anticipate market behaviour is so strong. Sparinvest is different. The strategy of strategic asset allocation has dominated both our corporate philosophy and the thinking behind the development of our entire product range for more than a decade. Until we discover scientific evidence to show that market movements can in some way be predicted, we genuinely dismiss the strategy of tactical allocation. Market timing and security selection are obviously important The problem is that nobody achieves long term success in the former and almost nobody in the latter. Asset allocation is the only factor affecting your investments that you can actually influence. William Bernstein, The Intelligent Asset Allocator Why Sparinvest Dismisses Tactical Allocation We agree with Bernstein s comment. The graph below shows the growth in value of $1 invested in the US S&P 500 stock market in 1926 until 2006, compared with a risk-free investment in Treasury Bills. It clearly demonstrates the superior performance potential of equities compared with bonds. However, the third column highlights the perils of trying to time the market. In this case, the best months of stock market performance accounted for only 4% of the total period. Dipping in and out of the market would not only have increased transaction costs, it would also have increased the likelihood of missing those periods where the market was delivering the most substantial profits. How much has 1 Dollar grown from 1926 to 2006? Source: Ibbotson Associates At Sparinvest, we believe that a constant exposure to the market will deliver more consistent returns over time than an investment approach that attempts to predict market movements. If we can t add value for investors by applying an active approach, then we prefer to achieve this exposure at a lower cost by means of passively-managed funds. Sparinvest Strategic Asset Allocation Strategy Page 5
A Common Sense Approach American Equities Annual Return Inflation Real Return 1802-1870 America as an emerging market 7.1% 0.1% 7.0% 1871-1925 America during industrialisation 7.2% 0.6% 6.6% 1926-2001 America as a mature market 10.2% 3.1% 6.9% 1802-2001 Return over two centuries 8.3% 1.4% 6.9% 1982-1999 (A similar rate of return occurred post Civil War from 1864-1880) 1982-2001 Dot com boom years (ended spectacularly in 2002) 17.3% 3.3% 13.6% 13.8 % 3.2% 10.5% Source: John C. Bogle, Common Sense on Mutual Funds Provided that investors are realistic in setting their goals for long-term investment, we believe that Sparinvest s prudent, strategic approach can help them to achieve a more stable and satisfactory return than they are likely to achieve with the tactical approach taken by other investment managers. Returns Distribution on Sample Portfolios Using strategic asset allocation, Sparinvest is able to create an optimal portfolio to deliver a specific annualised return or to remain within a given risk profile. The figure below calculates the return distribution from a portfolio designed for a risk-tolerant investor. 40% 30% 20% 10% 0% -10% -20% 1 2 3 4 5 10 15 20 25 50 Disaster Terrible Poor year Average Good Excellent Sensational Each of the vertical columns shows a wide range of possible outcomes ranging from sensationally good to disastrously bad that might occur over the time period indicated. Note how the volatility in average annual returns diminishes with each year that the portfolio is held. The figure below shows the returns distribution and volatility range that might be expected for the risk-tolerant investor compared with the risk-averse investor. What is clear here is the fact that the higher the return that is sought, the greater the degree of volatility that must be expected. Sparinvest Strategic Asset Allocation Strategy Page 6
40% 30% 20% 10% 0% -10% -20% 1 2 3 4 5 10 15 20 25 50 Disaster Terrible Poor year Average Good Excellent Sensational How Does Sparinvest Allocate Assets Strategically? Our booklet Strategic Asset Allocation in short gives a full explanation of how we apply the theory of strategic asset allocation to the portfolios that we manage on behalf of institutional investors. However, strategic asset allocation is also the basis for a range of funds that we offer to retail investors. Creating the best possible portfolio for each investor is a multi-stage process of which the most important aspect is, of course, the selection of assets. But the starting point in each case must be the investor and his/her individual requirements. Once we have determined the investor s risk profile, we can either begin work on creating a bespoke portfolio that will match that profile or else we can make recommendations about how to use our strategic asset allocation fund range to achieve a match. Sample Allocations Fund Range and Asset Allocation Securus Procedo Equitas Fixed Income 75% Equities 25% Fixed Income 35% Equities 65% Equities 100% Match Your Risk Profile Before considering any investment, the investor should first consider what level of risk is acceptable and what time horizon is appropriate: Sparinvest Strategic Asset Allocation Strategy Page 7
Longer time horizon / Greater risk appetite Shorter time horizon / Lower risk appetite Securus Procedo Equitas By investing in a combination of funds, most investors can achieve a sensible diversification and a well-behaved core investment to match their own attitude to risk and offset any future liabilities. Once the portfolio is established, the investment process is an ongoing one and has the constant objective of ensuring that the portfolio stays on track and in line with the strategic starting point. Investment Strategy (Process) 1. Screening universe of investments 4. Portfolio maintenance & rebalancing 2. Analysis & risk modeling 3. Selecting individual investments Summary Sparinvest s Strategic Asset Allocation investment objectives are: To offer continuous investment regardless of market movements To offer well-diversified portfolios, invested in a wide range of asset classes To use knowledge of asset correlations and volatility to construct portfolios that are suitable for investors risk appetites and time horizons To emphasize proven outperformance factors (currently size, value and momentum) to seek excess returns To retain portfolio allocations through regular rebalancing. Sparinvest Strategic Asset Allocation Strategy Page 8
Notes The mentioned sub-funds are part of Sparinvest SICAV, a Luxembourg-based, open-ended investment company. For further information we refer to the full and/or simplified prospectus and the current annual / semi-annual report of Sparinvest SICAV which can be obtained free of charge at the offices of Sparinvest or of appointed distributors together with the initial statutes of the funds and any subsequent changes to such statutes. Investments are only made on the basis of these documents. Past performance is no guarantee for future returns. Investors may not get back the full amount invested. Investments may be subject to foreign exchange risks. The investor bears a higher risk for investments into emerging markets. The indicated performance is calculated Net Asset Value to Net Asset Value in the fund s base currency, without consideration of subscription fees. For investors in Switzerland the funds representative and paying agent is RBC Dexia Services Bank S.A., Zurich Branch, Badenerstrasse 567, P.O. Box 101, CH-8066 Zurich. Published by Sparinvest, 28, Boulevard Royal, L-2449 Luxembourg. 20090525 Strategy SAA eng Sparinvest Strategic Asset Allocation Strategy Page 9