Regime Based Asset Allocation (RBAA) — Let the Data Talk

Published on 03 Apr, 2017

Quantitative Research Services

The growth of multi-asset portfolios in recent years has created a need to look beyond traditional asset allocation strategies. Different economic regimes produce significant impact on various asset returns and risks, albeit at varying degrees. Dynamically rebalanced asset classes have an established track record of increasing returns while reducing risk. A formal regime based asset allocation strategy could therefore be the optimal option for investors banking on multiple investment possibilities.

“When the facts change, I change my mind. What do you do, sir?
                                                                         
 -  John Maynard Keynes

Asset allocation is among the most important decisions any investor or fund manager will make.  Typically, investors and fund managers examine the composition of their portfolio in terms of investments in equity, bonds, and cash.  Historically, stocks and bonds haven’t moved in the same direction for long periods, and clubbing these two should help investors achieve the benefits of good diversification and reduce risk.

Traditionally, asset allocation techniques were based on the age and risk appetite of an investor.  Factors such as the age of a person affect the time horizon considered for the investment; assuming of course that they’re building a corpus fund over time in order to retire comfortably. Risk appetite provides an indication about how much they’re willing to lose in the short-term to achieve their long-term strategic goals, expecting higher growth in the corpus being built for retirement. An asset allocation rule of thumb is that an investor’s age should match the percentage of funds they’ve invested in bonds — so a 50 year old investor should invest at least 50% of his/her funds in bonds.

Asset allocation strategies are formulated based on investment goals, risk tolerance, time frames, and diversification. The most common forms of asset allocation are: strategic, dynamic, tactical, and core-satellite.

The emergence of multi-asset portfolios has allowed fund managers to look at Regime Based Asset Allocation (RBAA) strategies. There has been significant growth in multi-asset portfolios in the past few years, and it has sparked growing interest in the asset allocation practices that fund managers have developed to maximize their returns. 

Regime Based Asset Allocation

Multi asset strategy based investments amounted to around $2.8 trillion in 2015.  It’s expected to make up 10% of the global asset management industry, and represent 25% of the net new business over the next five years, according to BlackRock survey results. This has increased interest in multi-asset portfolios, enabling portfolio managers to look beyond just equity and bond markets

Even within the equity and bond markets, international markets provide different risk-return trade-off, and hence, are a very good avenue for diversification.  Commodities, currency, and alternative assets such as real-estate, infrastructure, and so on, provide excellent opportunities for investments.  The performance of these asset classes varies at different stages of the business cycle, and hence, combining them could provide more sustainable returns while managing risks at lower levels.  Regime based asset allocation aims to optimize this opportunity by moving in and out of various asset classes through strategies based on models developed specifically for this purpose.

Asset classes available for investments have been growing over the years, and their evolution can be roughly summarised as follows:Evolution of Asset Classes for InvestmentsThe addition of alternative investment opportunities helped the multi asset revolution.

To implement RBAA, one needs to thoroughly research the various opportunities existing for the investor by collecting and analyzing the performance of the markets and asset classes.  Regimes could be defined on the basis of GDP growth and inflation

The next illustration provides an idea about the possible regimes. One could split these regimes into finer points and create more than four regimes, if desired.Probability ModelA probability model needs to be developed in order to predict likely scenarios and regimes. Using these probability models, one could develop an optimization model and allocate resources to asset classes and markets. Constraints on the investment limits to asset classes, markets, sectors, and so on could be defined and implemented within the optimization problem. The complexity of probability models and optimization algorithms can be defined according to the fund manager’s specific requirements.

Evidently, regime based asset allocation is completely data-driven and doesn’t follow standard rules.  It also doesn’t depend on the age, risk appetite, investment horizon, or diversification. The availability of new data prompts investors to look at rebalancing their portfolios. Constructing a regime based asset allocation strategy, and systematically following it, is a very productive investment activity in during current economic climes. One could reduce the cost of transactions and management by including ETFs and ETPs in the portfolio.

All major asset management companies such as BNY Mellon and State Street uses different variations of the regime based asset allocation strategy.  With investors demanding higher returns and lower costs, more companies are devising customized versions of RBAA, and several funds would continue to move towards ETFs.

For instance, BNY Mellon research uses a macro-based RBAA, and shows that multi asset based portfolio outperformed the standard institutional portfolio by 1.6% net of fees, while the risk is lower by 3.2%.  This clearly shows the potential of RBAA. It also showed that RBAA portfolio performs exceedingly well during the Hot and Cold regimes.

State Street on the other hand uses a volatility-based regime definition that utilizes volatility clustering that’s observed in the market place. Their research shows that the RBAA based portfolio’s outperformed a traditional 60/40 portfolio by around 45bp, while risk is reduced by around 3%. The return/risk measure is 1.17 versus 0.70, and the drawdown is lower by more than 50%.

Thorough research based on a large set of data is important while creating a custom solution for a portfolio manager who wants to successfully implement the strategy.

A thoroughly curated list of asset classes and markets could be selected by the mandate and involvement of the managers; the following is an indicative list of what they’d likely consider:

Asset Class
Market/Assets


Stocks                                          

 

                              

US Stocks
 ·         Large Cap
 ·         Mid Cap
 ·         Small Cap
 ·         Sectors and Themes International Stocks
 ·         Developed Markets
 ·         Emerging Markets
 ·         Frontier Markets

International Stocks
 ·         Developed Markets
 ·         Emerging Markets
 ·         Frontier Markets


 

 

 Bonds                                             

 

 

 

US Bonds
 ·         US Treasury - T Bills, Notes, Bonds
 ·         TIPS 
 ·         Investment Grade
 ·         High Yield
 ·         Municipal Bonds
 ·         Asset Backed, Mortgage Backed

International Bonds
 ·         Treasury - T Bills, Notes, Bonds
 ·         Investment Grade
 ·         High Yield
 ·         Municipal Bonds
 ·         Asset Backed, Mortgage Backed


 Commodities

Oil, Gold, Silver

Other Metals

Other commodities

Currency

USD, Euro, JPY, GBP, etc.

Alternatives

Real Estate, REITs, Infrastructure

Passive

ETFs, ETPs

Derivatives

Traded and OTC derivatives

It is clear that the multi asset strategy could be very useful for active managers to outperform, while the investors are moving more and more funds to passive investments, particularly ETFs.  However, the definitions of regimes, quality of forecasting for the regime probabilities, and the performance of assets under the projected regime need to be well-defined. 



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