Asset Allocation Strategies

What is Asset Allocation?

Asset allocation is a fundamental investment activity that involves building and managing a portfolio of different asset classes such as equities, bonds, property, alternatives (including private equity, commodities, and hedge funds), or cash. The purpose of asset allocation is to deliver optimal risk-adjusted returns depending on predetermined investment objectives, risk limits, and time horizon.

Asset classes perform differently to each other in different market conditions – growth assets such as equities offer higher potential returns, but can be more volatile, while defensive assets such as bonds provide more stability, but with lower expected returns. As a result, constructing a diversified portfolio that strikes the right balance of allocation to different asset classes needs to be carefully considered to ensure the highest risk adjusted returns over a full market cycle.

The Importance of Asset Allocation

Asset allocation is one of the most important stages of the investment decision-making process. While security selection is where alpha (the excess return delivered above a benchmark, typically a market index such as the MSCI World) is usually generated within active portfolios, this is done after the portfolio’s asset mix is determined. Asset allocation will also largely determine the expected risk and return profile of a portfolio. For example, a higher allocation to equities should result in higher returns but will also result, almost certainly, in higher volatility over the long-term compared to a portfolio that is predominantly invested in bonds and cash equivalents such as money market funds. To set the asset weights within a portfolio, investors should consider a combination of aspects such as desired investment goals, risk tolerance, time horizon and liquidity.

The chart below shows the historical annualized returns of individual asset classes on a calendar year basis. From this it can be seen that different asset classes sometimes perform well in a given year, but then poorly in other years. For example, Commodities performed poorly in 2015 and 2020, with the lowest overall performance of all asset class, but then generated the best performance in 2021 and 2022 before falling back towards the bottom of the list in 2023. For any given asset class, their relative performance from one year to the next is not easy to predict. As a result, a portfolio with an allocation to a number of different asset classes increases the likelihood of having one of the good performing asset classes in a portfolio. The return of a well-diversified portfolio depends on:

• Its exposure to different asset classes and the correlation of returns between these asset classes.
• The individual weightings of these asset classes.
• The securities that have been picked within each asset class (as well as the number of positions held – more concentrated portfolios typically target higher returns).

Types of Asset Allocation

Generally speaking, there are three main approaches to asset allocation:

Strategic Asset Allocation (SAA)

Strategic Asset Allocation (SAA) is a long-term investment approach (typically with a horizon of 5-10 years or more) that seeks to establish a predetermined framework for combining different assets in the portfolio. It is based on the specific objectives and risk appetite of the investor and requires periodic rebalancing to maintain the original allocation. Its key advantage is consistency, which helps investors limit emotional decisions. Some studies suggest that SAA determines over 75% of the variability of returns associated with a portfolioBNP Paribas Wealth Management).

Dynamic Asset Allocation (DAA)

Dynamic Asset Allocation (DAA) is considered to be a medium-term approach, the dynamic asset allocation approach involves frequent adjustments to the portfolio is a response to market shifts. Although it involves intensive management (in most cases only professionals have the resource to leverage it) and higher transaction costs, it can deliver better relative returns during periods of elevated market volatility.

Tactical Asset Allocation (TAA)

Tactical Asset Allocation (TAA) as an approach focuses on the short-term and allows investors to re-position their portfolio away from their long-term Strategic Asset Allocation in order to benefit from short-term market conditions. While it is flexible and aims to enhance the portfolio returns, this approach is risky and its implementation requires high levels of expertise, time and resources. It also involves higher transaction costs due to its frequent trading nature. TAA can also be referred to as ‘Market Timing’.

Types of Asset Allocation Strategies

Income

Income investing is a popular approach with investors that want to generate a steady income stream, particularly with those that are approaching or are in retirement. The philosophy of income investing is to create a portfolio of primarily dividend-paying stocks and/or bonds that pay regular interest (also known as coupon). Typically, the companies that pay higher dividends (proportion of their profit distributed to shareholders) are well-established large entities within sectors like energy, financials, consumer goods and healthcare.

Below is an example of an income focused strategy and its asset allocation. The Franklin Global Multi-Asset Income Fund aims to achieve a level of total return consisting of income and capital appreciation, allowing it to support a steady level of annual distribution.

Balanced

A balanced approach would have exposure to both equities and bonds to reduce volatility. This strategy typically fits for investors with mid to long-term investment horizon and that have tolerance for short-term market volatility. It aims to provide a combination of income and capital growth, but also to preserve capital and provide downside protection. The approach is suitable for those who seek to build wealth over the long-term and have a moderate risk profile.

A popular example of a balanced strategy is the “60/40” portfolio, which invests 60% of the assets in equities and 40% in bonds. While the exact weightings are normally adjusted in-line with the investor’s specific objectives and risk, the approach seeks a balance between them. For example, should there be a sell off in equities (which are the growth engine of the portfolio), the bond portion hopefully will appreciate and reduce the overall risk of the portfolio.

Growth

Growth investing is suitable for those seeking above-market returns over the long term and can tolerate large market fluctuations. A growth portfolio typically consists of stocks that have the potential to deliver superior returns in the future. Examples are companies with small market capitalization that have intellectual property over a product/service and are expected to grow significantly their market share and earnings in the future. On the other hand, large companies that currently control a large market share, where barriers to enter are quite high, can also continue to experience above-market share price growth. Specific examples include the US tech giants Nvidia, Microsoft and Alphabet (Google).

Outside listed equities, asset classes that provide growth opportunities include:

• Private equity
• Venture Capital
• Hedge funds
• Emerging market and high yield bonds
• Opportunistic (i.e. assets with significant development or restructuring needs)

The chart below shows the historical performance of multiple portfolios based on different asset allocation models. On the far left we can see the performance of an income portfolio that is 100% invested in bonds, and moving right the allocation to equities increases. On the far right, we see a purely equity portfolio. The best and worst returns, as well as the average annual returns, are shown for each allocation model.

What are the Risks of Strategic and Tactical Allocation?

As the returns that a strategic asset allocation generates are normally derived from the systematic risk exposures of its underlying assets, changes to monetary policy, economic cycle shifts or rising inflation can be identified as potential risks. Although the approach provides stability through disciplined execution, its lack of flexibility may lead to unexpected return patterns during periods of market turbulence. The time frame of the strategy is generally long term, but that does not mean it will always perform well in the short term. Additionally, inflation may erode relative returns over time should the portfolio isn’t positioned to provide protection against rising prices.

On the other hand, tactical asset allocation seeks active risk to produce active returns. Investors express their short-term expectations on the future returns of different assets by determining the current point in the market cycle and going overweight or underweight in those asset classes relative to their strategic weight (which serves as a benchmark). The active risk feature of the tactical allocation can serve as a big performance detractor if the market timing (i.e. buying or selling at the wrong time) is poor. In addition, transaction costs should also be carefully calculated as they may erode the active returns.

Asset Allocation Examples

An example of an asset allocation can include:

• A conservative portfolio with 70% of the assets invested in bonds and 30% in equities.
• Balanced portfolio with 60% in stocks and 40% in bonds.
• An aggressive portfolio with 90% stocks and 10% in higher yielding bonds.

The below chart shows different asset allocation models by age for retirement and are based on an analysis that seeks to balance long-term return potential with anticipated short-term volatility.

Conclusion

To sum up, asset allocation is a fundamental part of the investment process and aims to provide the optimal portfolio structure for a given target return and risk appetite. An asset allocation strategy provides exposure to various asset classes that would perform differently during different market environments (i.e. would typically have low correlation), or alternatively would target a limited number of assets (and hence a higher level of risk) in pursuing higher returns.

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