In the western world, asset allocation advice driven by computer algorithms (Robo-Advisors) are posing serious threats to human advisory practice. If we believe in trends, then the time is not too far for us to do a catch up game.
One of the key determinants of portfolio optimization is the asset allocation strategy that you adopt for the client. Risk tolerance, return objectives, financial goals, time horizon, asset valuations etc. are factors that go in towards building an appropriate asset allocation.
Asset allocation is both art and science, and it’s the scientific side that we are covering here. Among the various strategies, the most popular ones are static, strategic, tactical and dynamic asset allocation models. Today, most of these models are being offered by asset managers themselves, but in the idealistic sense, it’s a proposition that an advisor should project as unique.
In the western world, asset allocation advice driven by computer algorithms (Robo-Advisors) are fast emerging and are posing serious threats to human advisory practice. If we believe in trends, then the time is not too far for us to do a catch up game. The question is how we get to a scientifically driven asset allocation model.
In this article, we have compared various strategies and its performance with empirical data for more than a decade. By the end of it, you would indeed be surprised with the output which clearly goes against the conventional hypothesis.
Static asset allocation (SAA): It is an approach to asset allocation in which the investor takes into account all the information available regarding:
i) macro-economic conditions,
ii) Performance expectations of the capital market and various asset classes over the time horizon of his intended investment,
iii) Own risk tolerance level and
iv) Risk-reward trade-off in terms of investment goal etc.
at the beginning of his investment while deciding the structure of investment and sticks to that original investment till the end without any re-balancing or change in proportion of the asset classes or any addition of other asset classes with the original mix.
Basically, it is a buy and hold strategy. For example, if an investor invests Rs. 1,000 for a period of 1 year with 35:30:35 ratio in large cap equity, small cap equity, and bonds respectively, he shall remain invested without any alteration in the asset mix or rebalancing to keep the same asset mix over the period.
The main tool used by the investor for minimizing risk while opting for SAA is diversification through investing into various asset classes having low correlation of returns among themselves.
Dynamic Asset Allocation (DAA): It is an approach to asset allocation in which the investor, based on his situation and goals, keeps adjusting the asset class mix in the portfolio in response to the changing market conditions, with the aim of getting higher returns.
DAA gives a lot of flexibility to the investor in general and the institutional investor in particular as there is no target asset mix to chase. The investor is free to respond to the change in market conditions as per his assessment of the situation. Therefore, for example, if the investor is initially bullish on equities, he may allocate large portion of his portfolio on equities. If after some time, he anticipates an impending bear market, he can sell equities and buy bonds as per his own assessment of the timing.
SAA can be considered as a special case of the DAA in which, the investor may opt not to change original investment structure based upon his assessment of market conditions.
Strategic Asset Allocation (StAA): It involves starting with a target asset mix and periodically rebalancing to restore that target asset mix. There might be a permissible range with a target allocation corresponding to each asset class as a tool of risk management. The portfolio formed using the strategic asset allocation technique is often called the policy portfolio.
Suppose a conservative investor has a strategic asset allocation target of 30:50:20 into equities, bonds, and cash respectively, with initial investment amount of Rs. 1 lakh for 5 years horizon, with re-balancing permissible at the end of each year. Investment starts at 01.01.2009. If in one year, the equities, bonds, and cash have given gross returns of 10%, 6%, and 4% respectively, then the values of the equity, bond, and cash components as on 31.12.2009 EOD are Rs. 33,000, Rs. 53,000, and Rs. 20,800 respectively, with total portfolio value at Rs. 1.06 lakh. Rebalancing would require the investor to sell equities worth RS. 960, buying bonds worth Rs. 400, and putting rest Rs. 560 in cash so that the asset mix reaches the target initially allocated. This process would be repeated on 31.12.2010, 31.12.2011, 31.12.2011, and 31.12.2012.
Tactical Asset Allocation (TAA): It is an approach to asset allocation which involves making short term adjustments to target asset class weights based on short term expected relative performance among asset classes. It can subsume a range of approaches, from occasional and ad hoc adjustments to frequent and model-based adjustments. When executed for the asset classes in many country markets, this approach is often called “global tactical asset allocation”.
TAA starts with a strategic asset allocation and adjusts it when the need arises based upon the assessment of the investor about the evolving market conditions and the potential returns various asset classes can give. Continuing with the example discussed in the StAA segment, assume that the investment strategy is TAA instead of strategic one. Let the returns be the same in 1st year as mentioned above. Suppose the investor anticipates an equity market boom in 2010, and wants to increase the equity exposure to 60%, while reducing that of bonds and cash to 30% and 10% respectively. Then, he would have to sell bonds worth RS. 20960, take Rs. 10,120 from cash, and invest the sum, viz. Rs. 31,080 in equities to achieve the short term target allocation of 60:30:10.
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Swarn Saurabh is a research analyst at Pulse Labs Research and Technology Solutions.
The views expressed in this article are solely of the author and do not necessarily reflect the views of Cafemutual.