The main principles behind DPA’s approach
Two well-established facts underpinning DPA Invest’s approach
The valuation of financial assets fluctuates wildly over time. For instance, long-term investors cannot reasonably expect the same rate of return on their investments if they acquire undervalued equity shares (e.g during the market trough in early 2003), or if they invest at much higher price levels (e.g during the “irrational exuberance” of autumn 2000). Similarly, investors are better off when they refrain from investing in vastly overvalued currencies, e.g the dollar against the euro in 2001. Overall, it is not hard to predict that, sooner or later, investors oblivious to fundamental valuation principles will face a reality check (see our columns in Enjeux Les Echos over the past five years)!
However, it is challenging to forecast when the price of an overvalued asset will revert back to a level more in line with economic fundamentals. The forces behind excessive valuations on financial markets (irrational behavior of investors, regulatory environment, public deficits or trade imbalances…) can persist for quite some time and «expensive» assets often become «very expensive» before reverting back to normal valuations. As the saying goes, « The market can stay irrational longer than you can stay solvent».
In other words, if an investor ignores fundamental valuation principles, he will certainly suffer in the long run. But nobody can predict accurately when he will feel the pain… (see our Research Papers).
Therefore, at DPA Invest, the investment process combines two steps:
In the long run, with, say, a 10-year horizon, returns are determined by economic fundamentals. In particular, they depend upon purchase prices since, in the long-term, investors always benefit from the acquisition of undervalued assets.
In the short run, however, the fundamental valuation of financial assets is largely irrelevant. The short-term dynamics of financial markets is shaped by other factors including financial ones (investors’ positions and their management, states’ issuance strategy, corporates’ financing flows, etc.), behavioral ones (e.g. investors’ risk aversion…) as well as surprises about the economic and political environments.
DPA Invest’s approach
Against this background, we believe that the proper investment process combines two approaches:
A strategic approach, with a long-term horizon, aims at answering the following question: What is the optimal portfolio for an investor with a 10-year horizon and without any views on short-term trends on financial markets? The structure of such a portfolio is shaped by the expected returns over that period for the various assets in the investment universe and by their related risks.
A tactical approach is concerned with the short-term dynamics at work in financial markets. It defines the portfolio for an investor with a 3-month to 1-year horizon.
To lay the foundations for these two approaches, and prior to any fund advisory or management services, DPA Invest follows a rigorous three-step process:
Evaluating asset returns over the long-run for an investor (see Asset returns over the long run), taking into account, in particular, current market valuations. This provides for each asset its risk premiums (see Risk Premiums Database) i.e. the difference between its expected returns and a risk-free money-market rate.
Building the strategic portfolio, i.e. the optimal portfolio for a long-term investor, keeping in mind his degree of risk aversion and his investment horizon. To that end, one needs an accurate description of the expected return and of the risks for each asset, at different horizons, and of the mean-reverting forces which bring valuations back to their equilibrium levels. For instance, after a severe downturn, equity markets usually bounce back if they were not initially overvalued. Such recoveries after a shock render equities less risky for a long-term investor than other assets, with similar volatility, but which do not exhibit similar mean-reversion features. DPA Invest has developed powerful tools, well-suited to describe the risks of financial assets dynamically and to build optimal strategic portfolios for investors (see DPA optimizing tools).
Analysis of short-term market trends (see Tactical Analysis), used to construct the tactical overlay.
Overall, the asset allocation for the funds we advise (e.g. LFP Allocation) or manage directly (e.g. DPA Gestion Privée) is optimized for a long term investor, with a strategic portfolio as a lynchpin. In addition, a tactical overlay, the result of short-term views on financial markets, is introduced in a transparent manner. The relative importance of short and long-term considerations is obviously adjusted to the particular needs of a given investor (and particularly his investment horizon and his risk-aversion).
