The valuation process considers equity and fixed income markets as well as cash. Blue Diamond calculates the fair value of the asset classes (divided in regions, market cap, and style) based on mean reversion over a full market cycle and analyses which asset classes, in combination, are likely to deliver returns above the relevant inflation measure. It seeks to avoid market bubbles and crashes by allocating capital dynamically to undervalued asset classes and staying out of expensive asset classes. We use fundamental factors to determine an asset class' fair value.
The asset classes equity and fixed income are divided in regions, market cap, and style. Each of these sub asset classes has an expected real return when the market is in equilibrium, fairly priced (grey number in the chart). As a matter of fact, markets are very rarely fairly priced and therefore the expected real return over the next years is not equal to the one when markets are in equilibrium. The number in black (and the column in blue) represents the expected real return p.a., over the next 7 years, to reach fair value, markets in equilibrium respectively (historically an asset class hits fair value in average all 7 years).
Real Return Forecast as of end of November 2011
These dynamic return forecasts change the risk/return characteristics of the asset classes. Instead of static numbers our approach considers the valuation of the asset classes before we allocate. Over time, the risk/return characteristics change, as the example between January 2007 and November 2011 illustrates:
Based on the risk adjusted real return forecasts we put together the ideal portfolio. The asset classes with the highest real return forecasts will get high allocations, the asset classes with low or even negative forecasts will not get an allocation or will even be shorted. The positions are built up over time to avoid a high turnover caused by short term market fluctuations.
