Strategic tilting: Guidelines for use in portfolios

August 2009

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FINANCIAL PROFESSIONAL USE ONLY

August 2009

Andrew Pease, Investment Strategist

Keynesian wisdom

� “The market can stay irrational for longer than you can stay solvent”

� “It is better to be roughly right than precisely wrong”

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� “Successful investing is about anticipating the anticipations of others”

Strategic tilting – the what

� Asset markets sometimes at extremes of pessimism or optimism

� How to take advantage of this

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� How to take advantage of this

� ‘Set and forget’ SAA

� a straight-jacket or

� a necessary discipline

Different to tactical asset allocation (TAA)

� TAA

� Frequent medium and low conviction positions

� Bias is to take positions

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� Strategic tilting

� High conviction positions

� Bias is to stay at your strategic asset allocation (SAA)

If only it was this simple

How Mean Reversion is Supposed to Work

+2 SD

Sell Sell Sell

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Source: Russell

Mean

- 2 SD

Buy Buy Buy

Time

But reality can be this

Getting the Mean Wrong

Estimate of Mean

+2 SD

Sell Sell

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Source: Russell

- 2 SD Buy Buy

OUCH!

Time

Strategic tilting - Can you?

� Avoid forecasts

� Imply spurious science and accuracy

� Stop listening when someone says “my model predicts…”

� Ignore market gurus

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� Become trapped by a view

� High profile experts want to be heard (right & boring versus wrong & interesting)

� Be pragmatic & disciplined

� Respect the market

� Have a disciplined process

Strategic Tilting – The Approach

� Two stage process

� Stage one: Asset class at an unsustainable extreme

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� Stage two: Conditions in place for a return to normal

� Macro indicators

� Stance of monetary & fiscal policy

� Investor sentiment

� Supply/demand balance

Example: investment grade credit

Investment Grade Corporate OAS

400

500

600

700

Bp

Our en t ry po in t

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0

100

200

300

400

1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

US

Global

Source: Barclays

Average since 1989

VIX is trending lower

Investment Grade Spread & VIX

60

70

80

90

4.5

5.5

6.5

7.5

VIX %

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10

20

30

40

50

1999 2001 2003 2005 2007 2009

0.5

1.5

2.5

3.5

4.5

VIX

US Invest m ent Grade Corps m inus Govt

Source: Barclays, Dat ast ream

CEO Confidence Signals EPS Recovery

CEO Confidence & S&P500 Operating EPS

10

20

30

40

50

60

70

80

% EPS Growth CEO Confidence Index

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-50

-40

-30

-20

-10

0

10

Q1 1989 Q1 1992 Q1 1995 Q1 1998 Q1 2001 Q1 2004 Q1 2007

20

30

40

50

Annual EPS grow t h

CEO Conf idence (advanced

t w o quar t ers)

Source: St andard & Poor 's, The Conf erence Board

Negat ive operat ing EPS in Q4

Current Strategic Tilting Views

� Credit tilt underway – upgraded from low in June to medium in July

� Equities versus bonds – good long-term value, not at valuation extreme

� No strong valuation gap between Aust and global equities

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� No strong valuation gap between Aust and global equities

� A-REITs cheap – but are they too concentrated?

� Global REITs cheap but so are global equities

� A$ expensive, but not at valuation extreme

Operating principles

1. First, do no harm

Bias is to do nothing.

Avoid false positives.

2. Process matters more than signals

More sophisticated models do not add value.

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Focus on the decision making process.

3. Attribution is essential

Know why a decision was made.

4. A clear exit strategy

Enter a trade with exit strategy in place. Markers need to be set.

Strategic Tilting – should you?

� You need the following:

– Capacity for longer-term view

– Committed to strategic tilting as a concept

– Continuity of decision making

– Ability to be dispassionate in reviewing decisions

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– Proper governance in place

� Can you cope with underperformance?

� Can your employer cope?

� Can your client cope?

Conclusion

� What? – High conviction, market extremes, occasional

� How? – Discipline & process

� Should? – not for everyone

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Ye shall know the truth, and the truth shall make you mad.

Aldous Huxley

It is one thing to praise discipline, and another to submit to it.

Miguel de Cervantes

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