Every investment strategy comes with its own set of risks. Here are some of what we consider to be the most important risks inherent in our process:
High turnover
- The PRATER process requires rebalancing on a weekly basis and has higher turnover than conventional portfolios.
- A simple two asset model will typically turn over 70% of net assets a year. A model with five asset classes may turn over 300% a year.
- Increased turnover will clearly lead to increased operational risk.
- In our opinion the extra returns are worth it, but investors need to be forewarned.
Portfolio concentration
- From time to time the models may become heavily concentrated in one asset class.
- This may contravene the terms of an investor’s mandate or internal guidelines.
- We stress that the only reason for this level of concentration is that the asset has the best return per unit of risk available at the time.
- This is why these models are best suited to tactical not strategic asset allocation mandates.
Timing and valuation risk
- The models are exposed to timing and relative valuation risks, which are different from many conventional value-based approaches.
- We use excess volatility as one of the inputs into the process. This makes equities look “expensive” after a period of high volatility, which is often associated with falling returns.
- On these occasions equities may look “cheap” on a conventional valuation basis.
- Many investors find it counter-intuitive, or just plain wrong, to avoid equities when they offer a high dividend yield or low PE ratio and then start buying only after they have started to rise.
- The point they often miss, is that while equities have been getting “cheaper”, bonds have probably been getting “more expensive” – i.e. producing positive returns with relatively low risk.
- There is of course no guarantee that equities or any other risk asset will continue to perform well once the model has rebuilt its exposure to those assets.