We’ve written about strategic asset allocation previously – the investment science behind the long- term allocation of investors’ capital across various asset classes.  In our view, strategic asset allocation (SAA) is one of, if not the most important decision an investor can make when developing a portfolio of investments.

The logic surrounding SAA is straightforward; a rigorous observation of an asset class’s historical performance overlaid with some contemporary assumptions about future performance in order to approximate an investment mix that best matches an investor’s return and risk expectations.

But investing isn’t simple and expected returns are an average of historical returns, with all the ups and downs in-between. Prices of financial assets don’t typically move in a straight line!

Strategic versus Tactical Allocation

Strategic asset allocations are reasonably enduring, ideally set for somewhere between five years to a decade and potentially lasting as long as a generation, on the understanding that intra-period reviews are carefully considered and undertaken to ensure a fit-for-purpose SAA.

Tactical asset allocation, or the short-term deviation of the investment mix away from the longer-term SAA, is an approach active investment managers use to navigate through the ups and downs of financial asset prices.

The logic of tactical asset allocation decision-making is about responding to opportunities, the known and unknown, either good or bad. The intention being to generate higher returns in favourable markets teamed with the aspiration to limit or mitigate losses when markets turn negative.

Most investors know that economic activity is cyclical, but how does an investment manager know that one stage of the economic cycle has been completed and that the next phase has begun? And by definition, who knows when the unexpected will actually happen?

Timing the market

What we do know is that markets, like the athletes at last month’s Paris Olympics, get fatigued. And when that happens they’re usually vulnerable to a correction.

Or think about sports’ betting. The first All Black’s versus Puma’s test match of this season had our local betting agency offering a $7.00 return for the Argentineans to win.

Who knew if the Argentineans would do the job or not? In the end they most certainly did, but the odds offered were based on old data about both the ABs and Argentina. The potential financial return - at $7 pay out on a $1 bet when there were only two teams competing - was very appealing and merited consideration.

The local punter most likely relies on a gut feeling prior to making a wager, but an investment manager should take a more empirical approach to short-term investment decision-making.

Earlier this month, who knew that the Reserve Bank of New Zealand (RBNZ) would officially signal the conclusion to its multi-year tightening of monetary policy with a 0.25% cut to the Official Cash Rate (OCR)?

While we’re guessing that most investors had a tactical asset allocation over-exposure to domestic fixed interest, we’re not sure if there was market consensus as to when the RBNZ would begin easing monetary policy?

Indeed, many market observers thought the RBNZ would start in August, and even more hoped that they would, but a lot of market commentators didn’t think they would move as quickly as they did. This uncertainty creates risk, and therefore opportunity, for reward.

Using the New Zealand Government 10-year bond (the “benchmark”) as a general proxy for domestic wholesale interest rates and bond yields, an ill-informed investor may not realise that most of the super normal profits usually associated with a sustained fall in the OCR may have already be taken, in the immediate short term, at least.

Here, we reference the performance of the Bloomberg NZBond Composite 0+ Yr Index, a core New Zealand fixed interest market index. For the 12 months to 13 August 2024 the index has delivered a super-normal gross return (pre fees and tax) of 9.05%. An astonishing return for a core, go-to, domestic fixed interest strategy, especially when considering that this was the annual return up to the day before the RBNZ announcement!

Undertaking technical analysis

Let’s take a look at what the statistics are saying about the 10- year benchmark’s yield action. Here investors could rely on the deviation of the yield from its moving average by observing Bollinger bands. Typically favouring a difference in these two metrics of two standard deviations, the more proactive investor could then collaborate signals from the Bollinger bands with other return data in order to satisfy themselves that they’re getting enough information, so as to form a more accurate view of the structure and integrity of the 10-year benchmark’s returns.

Without getting too much into the technical details, momentum is a measure of the price or yield ups and downs while the stochastic uses simple statistics to solve and display oversold or overbought price or yield activity. Financial asset prices, like those Olympic athletes in Paris, do get fatigued.

The chart below uses a bar graph to display the week’s high, low and close of the 10- year benchmark’ s yield, which are bordered by the Bollinger bands. Below that is the yield momentum followed by the stochastics displayed in the bottom panel.  

Chart 1: First strike, New Zealand Government 10- year bond benchmark weekly yield high, low and close are displayed in the bar graphs; Bollinger bands upper, median and lower values are displayed in the line graphs.