Regime Based Asset Allocation
Accounting for Macro shifts on asset class and portfolio performance

Rationale for Regime-Based Investment Approaches:
QMS Advisors believes that regime-based asset allocation combined with tail risk hedging has the potential to deliver significant benefits when compared to traditional investment policies, which are most commonly static and benchmark based. Contingent on economic foresight, implementation of a regime-based approach can potentially help mitigate downside risks and add to cumulative performance over time, translating to an improved distribution of overall portfolio returns.
  • Current macroeconomic uncertainties have translated into fat tails and significant negative skewness in the distribution curves of most asset classes' returns. QMS Advisors believes that these non-Normal features can arise from the mere possibility of multiple equilibria, even if those multiple equilibria individually appear normal. Empirical evidence also suggests that markets tend to settle in specific states after a short period of transit between states, and that they remain in those temporary states until new macro economic conditions develop.

  • Therefore the current regime-switching environment markets we are in indicate that the core building blocks of asset allocation and option pricing should allow for the possibility of multimodality. This in our view significantly changes the conceptual approach towards portfolio construction and risk management. 

Where to Allocate in 2013 based on QMS Advisors Regime-Based Macro Driven framework:

2012 offered numerous headwinds—from the rating downgrade of U.S. Treasuries to the continuing sovereign-debt crisis in Europe—so it should not come as a surprise that 2013 starts off with its own share of risks. Our Regime-Based Asset Allocation strategy for the year ahead entails overweight positions in global credit, real assets and alternatives—and underweight positions in government bonds, global public equities and cash. We believe the U.S. dollar will likely appreciate in the near term against the euro, and perceive multiple macro risks worth hedging, which stem from a potential slowdown in Europe, tensions in the Middle East, etc. Here we share these and other macro perspectives, addressing the key issue on investors’ minds right now: how to materially enhance returns through asset allocation in 2013.

  1. Our models recommend being significantly overweight credit-related fixed income, though positioning within the asset class does matter. Corporate Bonds are preferred to government debt in almost every area of the world except emerging markets, where both are attractive. Our favorites remain mezzanine, high yield and emerging-market debt.
  2. An overweight position in real assets, including gold, real estate and commodities. Among commodities, we prefer to sacrifice liquidity in certain instances in favor of owning assets that can deliver both return of and return on capital—as opposed to owning the more liquid commodity notes and indexes.
  3. We maintain that alternatives should constitute a greater share of an investor’s asset allocation. Some of our top choices are distressed and special-situation strategies, given ongoing deleveraging and headwinds in the financial services sector and in Europe.
  1. Our Regime-Based Asset Allocation models recommends being significantly underweight global government debt. At their current levels, safe-haven assets such as German Bunds and U.S. Treasuries appear to offer little value as buffers to a portfolio. Meanwhile, we remain skeptical of many higher-yielding sovereign bonds, as we believe that considerable risks lie ahead, including the possibility of European ratings downgrades.
  2. Our view on currencies remains that the U.S. dollar is still likely to appreciate in the near-term against the British pound and the Euro. Among emerging market currencies, we prefer Asian currencies to European currencies.
  3. We see at least three macro risks worth hedging in 2013. In Europe we expect an extended period of slower growth amid the volatility. Currently, however, the Euribor curve is pricing in a rebound in growth in 2013, so we think this mismatch in expectations is worth exploiting. Also, we aim to own some upside calls on Crude Oil in the event things do take a turn for the worse in 2013 and tensions surrounding Syria and Iran’s nuclear program escalate and causes oil to spike. Investors who are comfortable increasing their crude exposure at lower price levels could attempt to use the proceeds from writing out of the money puts or ATM down & In Puts to pay for upside OTM calls.

How does our Regime-Based Asset Allocation differ from our Strategic Allocation for 2013?
  • Our Regime-Based Asset Allocation currently favors income generating investments, and tends to seek non sovereign assets that offer upfront income stream to the allocation. our models put emphasis on lower credit within the fixed income allocation, and on dividend growth stocks within our equity allocation. 
  • Although QMS Advisors expects more monetary stimulus in the U.S. and Europe in 2013 in the form of quantitative easing, we do not anticipate a notable spike in inflation. This leads us to assume an overweight position in real assets. By gaining exposure to real assets through public (e.g., REITS) and private investments (e.g., infrastructure), we seek to obtain attractive capital appreciation and achieve return of capital along the way—an objective consistent with QMS Advisors desire to raise the overall yield in the portfolio.
  • By over-weighting our alternatives bucket, our intent is to secure large positions in long-term positions deep-value to take full advantage of the current market volatility in terms of both entry and exit points versus being beholden to it. Additionally, we want to be able to position ourselves across the capital structure as financing conditions fluctuate throughout the cycle. QMS Advisors also believes that alternatives are in many instances a better vehicle to capture key investment themes better. In particular, we desire exposure to special situations in Europe and consumer growth in Asia.
  • Risk and market exposure: we deem more important to devise thoughtful risk allocation than to reach specific statistical targets. Our Regime-Based Asset Allocation portfolio’s main sources of risk are overweight positions in credit, real assets, and other alternatives at the expense of sovereign debt and cash; however, our underweight position in global equities helps dampen some of our ex-ante risks.
We realize that a potential shortcoming in our Regime-Based target allocation strategy is that we are largely shunning government bonds, which have served—at least until recently—as volatility dampeners. But with real rates being negative in places like the U.S., and with sovereign credit ratings at risk in Europe, our model advocates reducing exposure to this asset class. Furthermore, rating downgrades of developed economies are likely to recur as a macro headwind in 2013.