ERAA® and Valuation Gaps
Co-founder and CIO
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StashAway’s system is continuously reading macroeconomic and market data. As a key feature of ERAA®, StashAway’s automated investment system continuously assesses asset class market valuations in comparison to their fair value. This difference is what we call a valuation gap. ERAA® seeks both overvaluations and undervaluations in assets to avoid investing in overvalued asset classes and to build positions when valuations are cheaper.
In the case that an asset is substantially overvalued, ERAA® will recommend a reduction in the exposure to the asset class, while in case of determined undervaluation, ERAA® will adjust upward the expected future returns and therefore increase the allocation toward the asset class.
To illustrate how this works, let’s check out an example of a time we re-optimised portfolios to account for a valuation gap.
In December 2017, our systems flagged significant undervaluation in Gold; moreover, the momentum for Gold had turned, and the asset class had started gaining value This triggered the re-optimisation of growth-seeking portfolios where the algorithm would increase allocations to Gold. This was done by selling other assets that were relatively expensive while keeping portfolio’s risk level constant. Not all portfolios were re-optimised. In this case, conservative portfolios on the platform were not affected because the changes would have been immaterial.
So, how did the system determine that Gold was undervalued? Let’s look at the valuation adjustment for Gold in Figure 1. The system looks at how an asset’s mean return is performing versus economic factors over a given time horizon.
Figure 1 – 7yr Valuation of Gold vs Growth, Inflation and Interest Rates
The red line represents the rolling 7yrs total returns of Gold over the last 20 years; the black line is the fair rolling 7yrs total return of Gold according to ERAA®’s valuation model, based on economic analysis. We are most interested in the difference between actual and model so that we can assess the valuation gap for Gold versus economic fundamentals. This valuation gap is depicted as the blue line that can be found at the bottom of Figure 1: Gold is undervalued with the blue line showing a 2 std deviations distance from the fair value. As historically the valuation gap has shown a clear “reverse to mean” behaviour, with the blue line always trending toward the mean, after Gold’s momentum turned, it was safe to assume its medium-term returns will be higher than historical.
For the above reasons, StashAway’s customers have increased their allocation to Gold in mid-december 2017. With a similar logic but opposite effect, at the time of writing StashAway customers do not have the broad US Large Cap Equities (SP500) in their portfolio, as the asset class is currently overvalued given where we are in the economic cycle; customers have exposure to US equities through a few selected sectors that offer more attractive valuation (technology, consumer discretionary and consumer staples) and have international equity exposure in markets where valuation are more fair and therefore return expectations are higher (e.g., Asia ex-Japan).