Aug 08, 2014, Originally published on Linkedin
“We do not time the market” is a statement you often hear from Wealth Managers as well as from Multi Asset and Balanced Fund Managers. Instead they claim to control risk by diversification across asset classes. This Strategic Asset Allocation (SAA) – often the Holy Grail – has rebalancing rules which indeed is a weak form of market timing. Already being the only timing component in such wealth management mandates, rebalancing plays only a subordinate role. The importance of market timing becomes clear when looking back on the last two decades and understanding this period’s anomaly in long-term perspective.
In the period 1995 to 2013, a bond market investment measured by the Vanguard Long-Term Bond Index Fund had only three negative years. More important, in the four years that equity markets (measured by the SPDR S&P 500 ETF) delivered negative returns, the bond fund had double digit returns on average. Therefore, it clearly eased the pain for those invested in balanced strategies during the heavy equity crashes at the beginning of the millennium and 2008. A Strategic Asset Allocation as simple as 60% stocks and 40% bonds would have worked with a quarterly, annual and even without any rebalancing. Returns are in a narrow range of 9% to 9.6% p.a. because both asset classes supported each other nicely. Neglecting rebalancing or even more explicit market timing seems to not have hurt during this period. We observed a free-rider market in which having constant long exposure in both asset classes might have satisfied return expectations of most clients.
What is the probability that these characteristics between bonds and equities will play out in that favorable way in the coming years? Is it realistic to assume that bonds will always be this nice fallback asset class, concealing major equity market drawdowns? What are the chances that both asset classes will continue to move up in tandem over several year periods?
While having no opinion on market timing might have worked in the past, we believe the role of a timing framework cannot be overestimated going forward. While it was sufficient to have annual or quarterly rebalancing just because it was common sense, it will be harder for wealth managers to argue for this rule of thumb when asset classes can deviate significantly for several years. For a scenario of bonds and equities falling in tandem no rebalancing rule will be sufficient. Market timing that reduces exposure or builds short exposure is needed. This applies in the two asset class scenario but also when adding commodities, high yields, you name it.
Now, some might argue that protection measures can be taken. It became popular to either explicitly buy protection by holding put options, or to reduce allocation to asset classes but write options to earn some income as an implicit protection. I argue that both of these overlay strategies also need a timing decision because volatility will not be steadily decreasing (on share buybacks, central bank liquidity etc.) forever. There are not many free lunches and some vanish from time to time.
Are wealth and fund managers who never had to deal with timing a market or timing a strategy, prepared to face the challenge? In the very interesting interview with Giovanni De Francisci on Opalesque TV, the family officer points out that there are too many free-riders with mediocre returns even in the hedge fund world. Demanding a conservative/low risk investment strategy must not be equalized with steady low returns. The long-term opportunity cost of missing to participate in strong upward movements, is a risk that often does not get attention while short-term volatility does. Purely relying on SAA without any market timing or with just arbitrarily selected rebalancing can have high opportunity costs.
Consequently, for wealth management there is no way around a solid decision making framework that encloses timing as a central part of any asset allocation.