ASSET ALLOCATION
THE BASICS
At its simplest, asset allocation is about asset classes such as equities, bonds, property, and the proportion of a portfolio at a particular time that is allocated to each. However, it can be, and often should be, more sophisticated than this.
Investment returns, whether absolute or relative to an index, are either related to ‘allocation’ or to ‘selection’ i.e. top down/systematic or bottom up/idiosyncratic. But how one defines the two is arbitrary – in some respects all returns are systematic. Even what appear to be purely idiosyncratic returns, have a systematic element.
SLICING AND DICING
Asset allocation starts with defining the various investment subsets to which allocations are to be made, either strategically or tactically. They can be based on asset classes such as bonds and equities and sectors within those asset classes. Or they can be based on a more involved analysis of the investment universe…
STRATEGICAL AND TACTICAL
You will have heard the terms strategic and tactical asset allocation but there is inconsistency in how they get defined. Perhaps the best way to think about the two is as follows. Strategic asset allocation to a multi-asset fund is what an index benchmark is to an equity fund. Tactical asset allocation is the equivalent of an active equity fund’s positions in relation to its index benchmark. Strategic is passive, tactical is active. Strategic is static, tactical is dynamic.
STRATEGIC
While a passive/active equity fund is run against an index benchmark that investors are interested in tracking/outperforming, the same goes for the strategic asset allocation of a multi-asset fund, passive or active. Thus, strategic asset allocation represents the first of two separate processes in relation to a multi-asset fund, determining an appropriate mix of equities, bonds, forex exposure that represent a good option for certain investors.
Given specific assumptions for returns, volatilities and correlations of each asset class, a strategic asset allocation can be constructed that offers the highest return for the lowest unit of volatility, arguably what every investor should aim for. This process is known as mean-variance optimisation and while in theory it makes sense, in practice it has its flaws which can be neatly summed up by the expression, “garbage in, garbage out”.
Assumptions about future behaviour of asset classes are often made on the basis that the future will mirror the past. These might be valid but sometimes are not. For example, a change in market regime, for example from low to high inflation, can herald a change in the way asset classes behave, particularly in relation to real returns. It is important when constructing an appropriate strategic asset allocation to factor in a change in regime that may be evident.
Some funds do not want a strategic asset allocation, preferring instead to think about things in purely absolute terms, achieving returns that exceed inflation by a certain margin for example.
tactical
Tactical asset allocation is the positioning in each defined asset class in relation either to a strategic asset allocation or some other basic allocation such as 100% cash. It is active in the sense that it involves, or should involve, predictions about future returns. If these future return predictions for a particular asset class are particularly high or low, it makes sense to take advantage of them by tactically allocating to or away from the asset class in question.
The way in which predictions are made is encapsulated in the investment philosophy of the fund manager. They can be based on technical or fundamental analysis. They can vary according to time frame; predictions can be made about short-term price movements, long-term movements, and everything in between.
DATA AND INFORMATION
Investing broadly is about turning data and information into investment decisions. This can either be done by humans, aided by computers, or solely by computers. There is an almost infinite amount of data and information that a fund manager could draw on. If he had the time which he doesn’t. Deciding what data and information to use is critical, as is deciding what to do with them.
INTERGRATED FRAMEWORK
The principles behind putting a robust asset allocation process in place are in many respect the same as those relating to investment process in general. Which asset classes to use, whether to employ strategic or tactical asset allocation or both, what sorts of asset class price movement should be predicted, how they are predicted, and what information and data sources are being drawn on, should all be part of a sound asset allocation process, part of an integrated framework. Moreover, for a process to be repeatable, it needs to be well documented. It must exist outside the minds of human beings.
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