Making sure of the right weighting
Judging from the data, equity markets are a no-go area at the moment but shrewd, quantitatively-driven asset allocation decisions still have their place
The top down approach is an investment allocation technique which requires the investor to make his decisions starting at the top of the allocation process. Normally the first decision to be made is the following:
Do I want to invest in equities or are there better alternatives to achieve superior returns with the lowest possible volatility?
The optimised allocation table (Chart 1) shows that the equities markets are very different to those markets that show the most favourable risk to reward ratio. In fact, the equity market occupies the lowest ranking because of the volatile and directionless movements that have occurred over the last 12-24 months.
The investment with the highest allocation weighting is the money market (is it really an investment?), closely followed by the high yield bond market and the global government bond markets. Altin is a hedge fund that was chosen to represent the major hedge fund indices. Preference is given to the highest weighting calculated by the allocation model.
How was the risk to reward ratio calculated?
No relative return indicator could be used, as the asset classes should be judged for their own merit. The equity markets have dropped to the lowest ranking over the last few weeks, as other classes showed more consistent returns with less volatility. Equity markets are therefore not the best choice right at this moment.
The standard deviation is a statistical concept that describes how a given distribution, in this case the weekly returns, varies around the mean observation. A low standard deviation is better.
The total return should be high as a strong absolute return is desirable.
Relative return measures could have been used for the stock market indices (see Chart 2), as they all indicate the MSCI World Index $ as their benchmark. There is however one important reason why they were not used. We would like to know which stock market indices show a better risk to return measure than the MSCI World Index$! There are in fact only two indices: the Czech and the Australian indices. No other indices offer a positive edge at the moment.
The European indices have recovered some ground over the last few months by climbing up from the lowest positions.
Which are the best Pan-European sectors?
This time a relative performance measure could be applied, as the MSCI World Index$ was used for all indices, including the main DJ Stoxx 600 Index (see Chart 3).
The indicator used is the information ratio over different time frames, which is basically designed to test the reliability of the excess return by relating it to its volatility. It is the ratio between excess return (the average of the relative monthly returns of the index versus the reference index) and the tracking error (the standard deviation of the excess return).
The medical products sector has been a leader over the last two years. Real estate has shown a similar performance as general interest rate levels have remained very low. The textile sector was supported by the stellar performance of Adidas and Puma. (See Chart 4.)
For further information on Brainpower’s professional portfolio analysis software, please visit www.brainpowerweb.com or contact Andrew Deakin on +44 (0) 20 7337 9123
