Tactical portfolio seeks substance and style

When I last rebalanced the Tactical Asset Allocation (TAA) portfolio in early January, there was a pro-risk bias. My optimistic view was that economies would open and there would be a strong recovery after the pandemic, so I made the choice to go with a high weighting to equities. Although the delta variant put a significant spanner in the works, that call wasn’t a bad one, the tactical mistake has been one of style not substance.

Overall, the total return from my portfolio since it rebalanced (8 January 2021 to 4 August 2021) has been 4.44 per cent. That’s not a disaster in seven months, but it’s an underperformance of benchmarks such as the PIMFA Private Investor Balanced Index. Over the same period, the PIMFA Balanced index (which is calculated and managed by MSCI) total return was 5.89 per cent.

Will TAA’s style choices be back in fashion in the second half of 2021?

Basic asset allocation hasn’t been the problem for TAA. Where it has fallen down is style. The PIMFA Balanced asset allocation splits its equity allocation between the MSCI UK index and a sterling-denominated version of the MSCI World index (excl UK). The latter holding is style-neutral; it doesn’t disproportionately favour value, growth or low volatility stocks just the market capitalisation weightings, whichever styles are in vogue.

PIMFA Balanced had 27.5 per cent of its overall weighting in the UK and 35 per cent in global stocks at the time TAA rebalanced. The UK holding by virtue of the significance of materials, oil & gas and broad financial stocks meant PIMFA Balanced had a much heftier exposure to the value rally at the start of the year. This is a big reason for TAA’s underperformance.

In terms of country risk, the UK forms a much smaller proportion of TAA, with the FTSE 100 exchange traded fund (ETF) making up 5 per cent of the last rebalance allocation. TAA’s equity exposure very much missed the value boat. Its main bias remained towards growth regions and themes, although the holdings were under the MSCI World index’s weightings when it comes to US technology stocks.

The US is about 60 per cent of the MSCI World index, but the S&P 500 ETF was 7.5 per cent of TAA at rebalance. Overall, the thematic exposure to infrastructure, robotics, environmental infrastructure, biotech and battery supply chain added to the S&P 500 tracker means that US stocks make up almost a third of TAA's equity exposure and over a fifth of the whole portfolio.

Thematic investing can bring added risks, such as overconcentration in less liquid small-cap stocks but several of the megatrends targeted by TAA have made positive returns. A reluctance to sell too soon was behind keeping the expensive Biotechnology Trust (BIOG) in January after it did well for the portfolio in 2020, but the valuation risk has caught up with it this year and it has been TAA’s biggest loser since January.

Other holdings that have done poorly include the Japan ETF and Schroder Asian Total Returns (ATR) is modestly down, too. In the case of the latter, the expensiveness of the trust (again after a good run last year) was a risk when I added it in January. That said, given the Chinese government’s crackdown on technology and education companies, I’m much more comfortable with this managed trust than I would be with a tracker for the region.

The ATR portfolio isn’t overly concentrated in the Chinese technology companies that have had a rough time with regulators, but it still has a hand in if they do recover. Overall, ATR's China and Hong Kong exposure is 35.4 per cent (as at the end of June according to the factsheet), whereas China now counts for almost half of many broad emerging market share indices.

What this holding gives the portfolio is an exposure to the value rerating that may happen in the next six to 12 months. Economies that have enormous rebound potential after the delta variant of Covid-19 disrupted their long-term growth story are well-represented, so ATR is a holding TAA is sticking with.

Likewise, the Japan and Eurozone ETFs have potential to deliver strong restart gains. Much of the muted performance of TAA this year has been due to the fact the pandemic has doggedly maintained its grip. This was always a possibility and it is pleasing that jumping the gun hasn’t resulted in paper losses, just underperformance. Belief in the holdings remains.

Will bond markets be able to look through inflation?

Central banks around the world have signalled strongly that there is no rush to tighten monetary policy in spite of rising inflation stoked partly by those very policies, as well as supply-chain constraints in materials and labour shortages in key industries.  The Bank of England held interest rates at 0.1 per cent at the MPC August meeting and showed very little inclination to slow down its asset repurchase programme.

In July the US Federal Reserve kicked the can down the road once more in terms of its rates policy and the European Central Bank has kept its key interest rates firmly in their lower bounds. With rising inflation, there is a risk that real interest rates fall to such a level that bond investors start selling out of government debt, forcing nominal market yields higher and having a knock-on effect for other asset classes.

The central bankers argue that inflation rises are transitory and they are watching wage growth as the key indicator of when economies really are running too hot. Controlling the narrative is important and little signals they will act to prevent inflation completely running amok are crucial to bond investors. If they are to accept negative real returns as the insurance price of holding an asset free of default risk, then they need to be sure the real cost of that insurance isn’t going to be allowed to spiral indefinitely.

TAA retains its holding in inflation-linked gilts, as these are sought-after in an environment where a lower nominal rate of return for rates is accepted. It must be said, however, that if bond investors do become restless then linkers won’t be exempt from volatility. The issues held in our ETF are typically longer-dated and the prices are more sensitive to changes in rates, something known as duration risk.

Where the risk no longer stacks up is in the corporate bond holdings. Sterling-denominated credit will be vulnerable to price falls if the rates markets hit trouble. Given the narrow spreads in yields over government debt, the compensation for that risk is no longer attractive.

Our High-Yield credit holding is also sold. This is partly because much of the largely US-denominated debt in the holding is doing the same high-risk, high-reward job for the portfolio as our US-dollar-denominated emerging market bond ETF. Recently, research by Bank of America highlighted that EM bond spreads are the highest relative to US High-Yield for 20 years.

Going (more) overweight equities

Reducing the fixed-income positions, the TAA is redeploying towards more stocks. We won’t rebalance the whole portfolio, just split the proceeds from the disposals between two new holdings.

Firstly, we beef up exposure to US tech with Allianz Technology Trust (ATT), which gets a 4.8 per cent weight. Its largest two holdings are Alphabet (GOOGL) and Amazon (AMZN), which goes against the idea of avoiding highly valued growth stocks vulnerable to inflation. That said, these businesses have defensive characteristics if the US restart stutters and buying the trust’s shares at a 7 per cent discount looks an attractive opportunity. Furthermore, over 60 per cent of the portfolio is in stocks with market caps below $100bn, so it’s by no means just a play on megacaps.

Feeling confident that the UK recovery has much further to go should Covid-19 cases continue to fall, the TAA reintroduces a mid-cap holding with the Vanguard FTSE 250 ETF (VMID). Finding quality companies at a reasonable price is difficult, but buying the index gives investors exposure to them, balanced out by the value stocks that could re-rate as the economy opens again.

Source: FactSet, Investors' Chronicle