How to optimise asset allocation?

Introduction

Markets and asset classes do not move in cohesion. What is in vogue today may not find flavour tomorrow. Asset allocation has always been a key to achieving one’s financial objectives. While a static asset allocation decision has always been implemented by various financial advisors on one’s individual portfolios, the actual implementation do change over a period of time influenced by various factors like macroeconomic, market behaviours and advisory intervention by investors and planners. So does it really makes sense to keep the originally planned strategic asset allocation as a constant or one need to do the tactical asset allocation based on various internal and external factors?

Though we all practice this sacrosanct process in some form or the other on a regular basis, one must look at the most crucial factor of portfolio performance asset allocation with regard to the strategic or tactical components.

Spreading one’s investments across different types of asset classes and markets—stocks, bonds, alternative investment avenues in domestic and foreign markets—lets you position yourself to seize opportunities as the performance cycle shifts from one market or asset class to another. An asset allocation plan doesn’t have to be complicated to be effective, but it should include the four basic asset classes i.e. equities, fixed income, money markets and alternate assets. As one’s investment portfolio expands, the financial advisor may suggest additional refinements to broaden the asset allocation.

The goal of asset allocation is to combine investments with different characteristics so that the risks inherent in any one investment can be balanced by assets that move in different cycles or respond to different market factors. Since market tends to rotate from one segment of the market to another, asset allocation can also help you gain exposure to the right segment. You won’t have to guess which asset class is going to do well each year if you already have exposure to many different segments of the market.

Asset allocation: Strategic & tactical decisions

The strategic asset allocation in the portfolio is made initially and reviewed regularly with the client. After the strategic asset allocation and investment allocation comes the need to review these financial objectives over the agreed review period. While the decisions are made keeping longer or pre-defined investment periods, it is imperative to review the changed dynamics in clients’ financial standings and external environment.

This tactical decision reviews the current macro-environment and makes minor but important adjustments in the asset class allocation to optimise portfolio returns. Most organisations have their own asset allocation models, criteria’s based on risk profiling and the asset class in which they operate in. The compelling reasons for doing so are the changing market cycles, performance and outlook on various asset classes, availability of new & attractive investment opportunities in/out of the asset classes, achievement of desired financial results/lackluster performance of that asset class over a period of time. These compelling reasons have been responsible for the tactical asset allocation approach.

The decision entails moving assets out of the agreed percentages as per risk profile to new defined allocation as advised by planners. Tactical asset allocation may work as an adjustment tool in the above mentioned circumstances. Though one may agree it is temporary in nature to exploit/adjust to the changed circumstances, the tactical asset allocation may last a longer time than one would think.

Let’s analyse all arguments in & favour of strategic & tactical asset allocation (Please refer to table 1)

Table 1

How to optimise asset allocation through various optimisation techniques

The decisions to change asset allocations are reviewed by investment committees, product managers or investment advisors themselves on a regular basis. The inputs required to make the tactical choices are very critical for the relevant decision makers.

There are models which can be built to provide the asset allocation optimisation to take tactical decisions in the portfolios. The models usually takes inputs from various macroeconomic factors such as GDP growth, inflation, interest rates, currency, past performance as well as futuristic expectations/views of the market and also contains the investors’ or wealth managers’ views. A reliable set of expectations about return, risk, and correlations is essential to building optimal decisions.

Wealth managers can use the robust optimisation inputs or incorporate these models to create their own asset allocation decisions. The kinds of reports which can be extracted through those models include optimal asset allocation, efficient frontier for asset allocation decisions, attribution analysis for risk-return analysis and sensitivity & scenario analysis. For predicting expected returns & reducing risk the following factors could be considered: Past performance, expected macro variables (GDP, inflation, etc.), EPS, interest rates/monetary policy, international market inputs and investor views can also be incorporated allocating based on optimised levels.

Asset allocation models

Asset allocation models need to take several factors into consideration while coming up with tactical allocations. Apart from over all investor objectives of return maximization and risk limits, other factors like market allocation, movement in economic factors, investors/advisor’s view, behavior of various asset returns become part of asset allocation model. How good an asset allocation is, would depend upon how each of these pieces are blended into the final model. Various steps towards achieving the right blend are described here and drawn in the flow chart A below:

• Economic factors used for getting parameters for optimization: These are the factors described above viz GDP growth rate, inflation, EPS of equities, monetary policy variables (interest rates, etc.). These factors reflect the current economic scenario and help in projecting future returns.
• Time series analysis to link economic factors and asset class performance: These models link the performance of various asset classes to economic factors. Thus the output of this model would be a projection of future returns based on macro-economic scenarios in a quantitative way.
• Investor/advisor’s views for inputs: Most often than not every investor has his/her own views driven by experience of understanding of the markets. Similarly expert financial advisors also have views on various asset classes. A good asset allocation model should have a feature to integrate these views into the allocation scheme.
• Black-Litterman model: The basis of tactical allocation should be relevant to current market condition and investors views, at the same time the allocation should not deviate too much from market capitalization or else the investor would be taking surplus idiosyncratic risk. From this perspective Black Litterman and similar models give a good way to blend in investors’ views, economic reality and market capitalizations.
• Mean variance optimisation with & Monte-Carlo simulation (re-sampling): These techniques allow one to optimize the returns coming out of a portfolio for various risk levels. These techniques are computationally intensive and careful modeling is required to achieve correct results.
• Efficient frontier for various risk & return scenarios: Not every investor has the same risk preference. The risk preference of an investor depends upon his liquidity, other liabilities, sources of income, risk raking nature, age, etc. Thus an idea asset allocation model should build an efficient frontier providing various risk and return scenarios from which the investor/advisor can choose from. The final asset allocation would depend upon the risk level chosen.

Conclusion

While strategic allocation may get justified for very long-term periods and static markets but in today’s ever-changing markets and investor awareness of market performance, a tactical approach holds an upper hand due to reasons discussed here. Thus it is imperative for advisors to keep a dynamic approach to investment decisions keeping the basic tenets of asset allocation in place to maximise portfolio performance using the models described above and implementing it in client portfolios.

The author is a Certified Financial Planner^CM, business consultant and an advisor.