ADS Analytics Sector Allocation Framework
This framework collates our quantitative sector metrics along with asset fundamentals and the state of the macro cycle. Very little of this framework is based on our own views – that is, we try to avoid basing a sector rating on what we think will happen. Our philosophy rather reflects that of Howard Marks who has written:
It’s my strong view that, while they may not know what lies ahead, investors can enhance their likelihood of success if they base their actions on a sense for where the market stands in its cycle.
What is covered by the framework?
The framework primarily covers the closed-end fund market. In our individual sector analysis we typically include ETFs as (usually) unleveraged passive sector benchmarks. The asset fundamental commentary is applicable to ETFs as well, however other quantitative metrics having to do with discounts and yields do not apply.
The framework only covers those sectors which we think of as income asset sectors so pure-equity and hybrid sectors are not included, however sectors like covered calls which have a similar risk profile are included because of their income-generating ability.
What do the ratings mean?
The sector ratings are designed to be qualitative and illustrative rather than prescriptive. We deliberately avoid specific allocations because we expect different investors to operate with different utility functions and risk/reward targets and budgets.
Rather, our framework uses a scaling of -3 through +3 to indicate preferences based on our assessment of likely risk-adjusted returns over the medium-term horizon. The ratings are not designed to be evenly balanced, although in aggregate they should not deviate significantly from an overall neutral level. We assume a roughly 6-12 month horizon.
What drives ratings?
We divide the drivers of ratings into three broad categories.
- Asset fundamentals – depending on the asset class : corporate margins, earnings growth as well as the creditworthiness of corporate debt and housing market and household balance sheet health.
- Macro and market environment – overall valuations of underlying assets such as government and corporate bonds and stocks, as well as the stance of monetary and fiscal policies, inflation, financial conditions and the presence of any financial imbalances
- Quantitative factors
- Valuations: Discount, Z-Score, RSI
- Diversification: Pairwise correlation to other sectors, correlation to stocks and bonds
- Volatility: price and NAV volatility
- Yield: past 12-month distribution rate, 1-year change, historic percentile, 5y distribution change.
There is no hard and fast rule with which these metrics translate into a rating so there is some discretion involved.
How can investors use this framework in their investment process?
Our goal in introducing this framework is to spur thoughts and discussion around portfolio construction, performance drivers and risk/reward objectives. We think the process necessary for building a holistic view of the closed-end fund space and distill it into this framework helps avoid behavioral biases and blind spots. At the very least, if the framework brings additional evidence-based rigor to our analysis, then it will have achieved its goal.
