Asset allocation is now the main game in town and Michael Block gives an insight into how he approached it during his time as CIO with Australian Catholic Super.
In a world where superannuation funds are assessed on how well their individual asset classes perform against an Australian Prudential Regulation Authority (APRA) benchmark, changing asset allocation is the best method to improve performance (especially relative to peers) in a way that will not increase regulatory risk, Michael Block says.
Traditional ways of adding alpha, including manager selection or niche strategies, are riskier under the Your Future, Your Super (YFYS) performance test, the former Chief Investment Officer of the Australian Catholic Superannuation and Retirement Fund (ACS) says in an interview with [i3] Insights.
“My prediction is that in a YFYS world, even with the YFYS now having been adjusted a bit, asset allocation will become more prominent in super funds because one of the only ways you can beat your peers in terms of relative performance without exposing your fund to failing the YFYS performance assessment is to have a slightly different asset allocation,” Block says.
“If you try to do it through stock picking or manager selection, then it’s dangerous because you have to run the full gamut of the YFYS test. But you can change asset allocation as much as you like, as long as you update your disclosed SAA (strategic asset allocation) with APRA without it affecting your YFYS outcomes.”
Making periodic adjustments to SAA and adjusting a fund’s disclosure documents and APRA reporting (for example, SRF533) is not the same as using dynamic asset allocation (DAA) while keeping the SAA constant, a practice which exposes a fund to underperformance against its YFYS benchmark.
What this means is that if a fund chooses to practice DAA, then it will likely have to publish a new SAA rather than live with the effects of the asset allocation changes as a temporary tilt.
My prediction is that in a YFYS world, even with the YFYS now having been adjusted a bit, asset allocation will become more prominent in super funds because one of the only ways you can beat your peers in terms of relative performance without exposing your fund to failing the YFYS performance assessment is to have a slightly different asset allocation
Block is well known for his preference for asset allocation over manager selection and says he and his team could recommend taking positions away from the SAA of up to 15 per cent in a single asset class while at ACS.
“At Australian Catholic Super, the Investment Governance Framework allowed a four per cent deviation away from SAA before an instantaneous rebalance was required. The four per cent allowable deviation was two per cent of FUM (funds under management) from market price movements and a further two per cent that the investment team could institute without having to seek approval from the investment committee,” he says.
Separate to the allowable rebalancing thresholds, the fund occasionally could make more significant formal asset allocation changes.
“The fund could have five, 10 or 15 per cent changes to the allocation to a single asset class with approval of the investment committee. So, for one of ACS’s 70 per cent equities options, it could have its equities allocation reduced to the mid-fifties if the fund had negative views about the market, as it did in late 2019,” Block says.
“And that paid off on occasion. Generally, what happened was we were too early and we wore some pain because we were less in growth assets when the market continued to rise, but it often turned out well in the end.
“For example, we reduced our equity exposure in late 2019. Then along came COVID-19 in March 2020 and we were very underweight equities and it looked like a genius call. However, in reality, we did not see COVID-19 coming and the great result of our underweight position and subsequent short covering was partly luck.”
He says one of the hardest calls to make in asset allocation is not the decision to sell assets, but to buy them back, because often this needs to happen at times when uncertainty is at its peak.
“I’m proud of going underweight equities, which was very brave of Chris Drew, John Phokos, Paul Conraads and Catherine Bussier, but equally proud that we had the courage to buy the equities back when we were in the middle of COVID-19,” he says.
“Everybody thought financial markets were falling apart. Some people did a bit of rebalancing. Mine Super, for example, did some good work in this area by adding risk in March/April 2020.”
During this period, Block drew upon the teachings of his asset allocation hero, Jeremy Grantham of GMO, and recommended the fund “reinvest when terrified”.
Often when faced with major market dislocations, funds suspend rebalancing activity and often the catch-cry was: “Don’t do anything; don’t even rebalance. The world’s falling apart.”
“That is why I am so proud of my colleagues, the investment committee, especially David Hartley, and myself for having the courage to buy what turned out to be cheap assets in March 2020 when others were too scared to move,” Block says.
Price, Not Timing
So, when is it the right time to shift asset allocation? The old adage of “time in the market, not timing the market” is one that is held dear by many long-term investors. Block says it is not about timing, but simply about price.
Investors need to have a view on what the fair value of an asset is and if the price goes below that, then it is time to buy and if it is above it, then it is time to sell. It is as simple as that, Block says.
“How do you know what low and high is? This is a very hard and complex question. I do have an answer for you in every asset class, but it is far from perfect,” he says.
“For example, in equities we use the Shiller PE, in currency rates we use either the real effective exchange rate or the Big Mac Index, otherwise known as purchasing power parity, or we use both.
“Right now I do not have a strong opinion on whether the Aussie dollar goes up or down. But when it was at 50 cents, I had a strong opinion that it would go up, and when it was at $1.10, I had a strong opinion that it would go down.
“Essentially, I am more confident or have a higher conviction when prices are further away, very far away, such as three standard deviations or more, from assessed fair value.
“So, my modus operandi could be summarised as stick to a robust SAA, except when prices are significantly away from equilibrium. In other words, in relation to tilting or DAA, when in doubt, leave it out.”
But key to implementing a successful approach to asset allocation is not waiting until assets hit your expected fair value level, but moving incrementally as the price moves.
“You cannot always wait until the price reaches your target, after all, what if it never reaches that number? For example, at ACS, we had a ladder program in our currency hedging program,” Block says.
Right now I do not have a strong opinion on whether the Aussie dollar goes up or down. But when it was at 50 cents, I had a strong opinion that it would go up, and when it was at $1.10, I had a strong opinion that it would go down
“What this means is that if we thought the Aussie dollar was worth 66 cents and it goes up to 70, we sell some. If it goes up to 75, we sell some more.
“If it goes back to 70, we buy it back. So, we made money just simply rebalancing around fair value. It sounds simple, but one has to have in mind what we think the equilibrium value is and to have the courage to place the orders in the market in advance.
“And the other thing we do, for psychological reasons, is we often do not place order limits at round numbers. If the dollar is at 66 cents and the first target at which we are looking to sell some Aussie dollars is 70, then we probably sell it at 69.40 or 69.90 or a number like that. This is because turning points tend to be near big round numbers.”
Having a disciplined approach to this is important and the fund had preset trades in the market in case certain barriers were broken. Having a preset strategy also allows trades to happen in real time, rather than having to make decisions when markets are in turmoil.
Block illustrates his point using two key geopolitical events: Brexit and the election of Donald Trump as President of the United States.
“There was Brexit and there was Trump’s victory when markets moved dramatically intraday. Because we already had all the orders in the market and our brokers had instructions – if the market goes down, buy some stock, if it goes back up again, sell it – we were able to take advantage of these big swings and crystallise profits,” he says.
“With so many other super funds, when market changes are large enough to trigger a rebalance or DAA move, one usually is required to seek approval to trade. Our investment committee approved trading strategy and consequent orders were already in the market, giving us a great timing advantage.”
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.