For long-term investors it is common to design a long-term investment strategy, which aims to generate return to reach their objectives (e.g. long-term benefit payments). However, every investor knows that a lot can happen between now and the long term. A good example is the current low yield environment, the potential reversion to higher interest rates and the impact this may have on equity returns. The definition of a strategic risk budget enables to act on such market circumstances, in a controlled way without violating the long-term investment strategy. It facilitates Dynamic Asset Allocation (DAA) for top-down risk on/ risk off decisions in addition to the long-term strategy.
The main question that of course arises is which signal to incorporate when making these risk on / risk off decisions. A portfolio construction back-test (1999-2017) shows clear added value of using the Ortec Finance Scenarios (OFS) for annual DAA decisions to generate excess return compared to a static SAA.
The OFS provides dynamic stochastic scenarios with up to date and realistic expectations of risk and returns for both short and long horizons. Its design is based on the premise that there is an underlying structure in how markets tend to fluctuate in reality. It takes into account the actual economic and financial market circumstances, as well as the effects of interventions by central banks and governments.
The back-test shows that a dynamic strategy, based on risk and return expectations from OFS, clearly adds value: it delivered an additional annual return in almost all years (net of transaction costs). Download the full article to read more about this research and the intuition behind the results