Smaller, more frequent asset-allocation choices made from the ground up may reduce the risk of a disastrous market call, says Invesco’s Scott Wolle
At the start of 2014, it seemed to be universally accepted that Treasury bond yields would eventually increase and that the bonds should be shunned. But things didn’t work out that way: The yield on the 10-year Treasury declined from 3.03% to 2.17%, as of Dec. 31, 2014.
The problem with the big bets against Treasuries isn’t that they were wrong, says Scott Wolle, co-manager of the Invesco Balanced-Risk Allocation (IBRA) and Global Market Strategy (GMS) funds. It was that they were big. Where investors tend to mess up, he says, is in building portfolios whose success depends on getting a single asset-allocation call right. “Traditional allocation involves saying, ‘If I like stocks, I’ve got to sell bonds,’” Wolle says. “That, in effect, makes for a one-decision portfolio and potentially leads to a situation where if you’re wrong, you can be catastrophically wrong.”
Wolle considers it more prudent to make many smaller, independent allocation choices. It’s an approach he finds particularly useful for funds like IBRA and GMS, which seeks to cover investors in three major environments: recession, non- inflationary growth and inflationary growth. The funds have close to $9 billion (as of Dec. 31, 2014) in assets to allocate across stocks, bonds and commodities—and broad discretion in how and where to do it. “We’d rather have lots of modestly sized, independent positions,” Wolle explains. “We’re certainly going to be wrong on those assets at one time or another, but if we scale the risk right, it’s less likely that we’re going to be wrong in all of them at the same time and have those really big losses that are so difficult for investors to bear.”
What many asset allocators, and professional investors in general, tend to do wrong, he contends, is underestimate the possibility that they indeed are wrong. Wolle cites the research of Philip Tetlock, a professor of psychology and management at the University of Pennsylvania, who has found that putative financial experts are inclined to explain away developments that run contrary to their forecasts instead of adjusting their thinking to account for fresh evidence. “It seems really simple,” Wolle says. “You must be willing to change your mind.”
But like virtually everything else in investing, changing one’s mind should be part of a disciplined process, he says. Otherwise, a change in opinion can easily be grounded in a potentially unwise response to greed and fear. Wolle’s team systematically measures a diverse set of inputs—including valuation, the economic environment and price trends—to gauge the attractiveness of each asset in their universe. Today, for example, the team agrees with most observers that U.S. Treasury bond yields are lower than they should be (that is, overvalued). But the team thinks conditions are not yet in place for them to move substantially higher in the near term. (an example of economic environment and price trend).
Simply making better individual forecasts, however, isn’t enough, says Wolle, who stresses that diversification is just as important in tactical allocation. His team has a view on each of the 25 assets in the IBRA and GMS portfolios—developed equity markets, sovereign bond markets and individual commodities. The goal is for each to be as independent as possible. The team wants each individual asset category to have the potential to contribute the same amount of tactical risk. So lower-volatility assets like sovereign bonds have larger ranges, while more volatile assets like stocks and commodities have narrower allocation ranges. In this way, the same degree of conviction on two assets theoretically results in the same expected impact on the portfolio. Thus, if one is wrong, the other, if correct, potentially can offset the first.
In Wolle’s view, some allocation errors occur even before market calls are made. For instance, using capitalization-weighted global stock indexes as benchmarks can add a bias toward owning countries that are expensive and at greater risk of declining, he believes. That’s because the most heavily weighted index constituents are the ones that, among other factors, have had big price runups. “If you have very high valuations, you’re at much higher risk of future negative returns,” he says. “The allocation process for IBRA and GMS strategically emphasize less expensive markets and deemphasizes those that are more expensive. We think that the U.S. is expensive relative to the rest of the world. Asia is looking increasingly interesting, and Europe still looks as if it’s priced below its norm. The U.S. is really the outlier in the world right now, particularly small caps.”
As for bonds, Wolle says, many fixed-income market segments, including high yield, trade in line with equities. So he prefers to focus on Treasury instruments. But he views their role in portfolio construction as fundamentally different from that of other assets and suggests that market prognosticators are mistaken when they try to make “all in or all out” calls on Treasuries. It’s not that he expects the forecasters to come up with the wrong answer; it’s more that he thinks they’re asking the wrong question. “The way we use bonds is to [hedge against downside risk],” he explains. “If you own Treasuries because you think you’re going to make a fortune because yields are going to 1%, that’s a bad idea.”
Treasuries tend to rise in value when real growth and inflation slow, precisely the time when many other asset classes struggle, Wolle explains. While that doesn’t mean that investors shouldn’t consider smaller allocations when Treasuries have an unattractive risk/reward tradeoff, he says, the reduction has to be consistent with the diversification of multiple tactical positions. “If you own them out of enlightened ignorance—because you think that bad stuff is going to happen but you’re not confident about when—then that’s probably a good reason to have them in your portfolio.”
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