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Wealth Manager exclusive: Smart Benchmark IV helping dynamically manage asset allocation

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Smart Benchmark is a proprietary approach to dynamic strategic asset allocation used by BNP Paribas Investment Partners’ Global Balanced Solutions team.

It launched in 2002 to help improve the risk-return profile of the GBS team’s range of balanced mutual funds. Its last incarnation – Smart Benchmark III – was designed to profit from the widening credit spreads and low valuations that emerged out of the ’08 financial crisis. Conditions have changed in 2011, however, and back in June, the GBS team rolled out Smart Benchmark IV as equity risk premia moved closer to long-run averages and credit spreads tightened.

“It’s not a wholesale change to the system, we’ve just updated it,” says Chris Jeffery (pictured), Senior Global Economist, Global Balanced Solutions, in a press briefing on 12 September entitled: “The importance of dynamically managing your strategic allocation”.

The GBS team distinguishes between three types of asset allocation: long-term strategic allocation, dynamic strategic allocation over a 5-7 year horizon (“Smart Benchmark”), and short-term tactical asset allocation. Gina Wilton, Investment Specialist, Global Balanced Solutions, said that whilst strategic asset allocation is generally considered to be quite static and unchanging over a long-term horizon, “we think you can benefit by adjusting risk over a medium-term horizon”.

At its core, Smart Benchmark is designed to increased risk-adjusted returns on a structural basis, across asset classes. “In each asset class we produce our own risk/return assumptions and update these regularly, as required,” says Wilton.

The system’s model builds expected returns for each asset class over a full market cycle, which it assumes to be seven years. In the GBS team’s view, smart benchmarks are the best way to capture the higher return potential of diversification without taking on unnecessarily high portfolio risk. By way of example, in May 2009 Smart Benchmark III adjusted its position within the credit space by increasing portfolio weighting in both investment grade and high yield debt.

“We increased our exposure because of the sharp dislocation we saw between bond valuations and fundamentals,” explained Wilton. Everything the smart benchmark does is based on how cheap a particular asset is. Unlike tactical asset allocation, which uses a short-term (3 to 12 months) horizon and can go both long and short relative to the benchmark, dynamic strategic asset allocation is a pure long-only play across the medium-term.

Today, Smart Benchmark IV sees good long-term prospects for Emerging Market equities and has subsequently increased its exposure (relative to SB III) from 12 per cent to 14 per cent. Conversely, short-term growth prospects in this asset class are less encouraging: the team’s tactical asset allocation has been neutral since July 2011.

Jeffery said Smart Benchmark IV had been positioned, in light of today’s market environment, so as to capitalise on five key themes:

Reduce risk due to less attractive risk-return trade-offs
Reduce portfolio duration as interest rates likely to rise
Reduce credit exposure due to tightening spreads
Increase allocation to emerging markets
Introduce long volatility as diversifying asset class

A reduction in global long-term interest rates has created riskier market conditions within equities so it would seem obvious to reduce risk exposure. Due to the threat of rising government bond yields, which still remain nominally low, SB IV recommends reducing portfolio duration risk by favouring short-dated bonds instead. The GBS team anticipates European government bond returns of 3 per cent this year.

Tightening spreads between high yield corporate bonds and IG bonds have resulted in SB IV reducing exposure to Euro government bonds (down from 6 per cent to 4 per cent) although it has increased allocation to emerging market external debt (up from 0.8 per cent to 3 per cent).

Emerging Market equities are seen as a real growth opportunity for the GBS team. “We don’t believe they are overvalued. In our view, they’re trading at a 10 to 15 per cent discount on a trailing P/E basis,” says Jeffery, citing strong GDP and earnings growth as being supportive of upward price momentum.

On introducing Euro long volatility as a new asset class, Jeffery pointed it that this wasn’t a knee-jerk decision based on recent market dynamics but something that had been carefully considered, noting that the capability just wasn’t there previously.

“It’s useful to get exposure to equity volatility in times of crisis. We don’t think investors will make much consistently from volatility but it’s an important piece of the portfolio puzzle. Adding volatility to a balanced portfolio can provide significant diversification benefits which are worth paying a premium for,” says Jeffery.

Dynamically adapting mid-term benchmarks and being able to rely on nine years’ worth of research and experience appear to be working in the GBS team’s favour.

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