Choose Your Own Asset Allocation Adventure

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Portfolio construction starts after the investment advisor and investor formulate a realistic investment objective or spending plan. Only then can real portfolio magic occur. This article will break down four different ways to allocate the assets in your portfolio to help keep your investments balanced and growing.

SEE: A Guide To Portfolio Construction

1. Strategic Asset Allocation
Once the investment objective or spending plan is complete, the asset mix for strategic asset allocation generally adheres to the expected performance of asset classes. Given the long-term nature of investment objective constraints, the investment advisor will develop a long-term forecast.

SEE: Achieving Optimal Asset Allocation

A range of forecasting methods exists, but a simple and popular method relies on mean reversion, where the asset class's performance tends to converge to the average long-term performance. A more precise method relies on using long-term forecasts of important economic variables, particularly inflation, as these can dramatically affect future wealth and spending.

For example, if the inflation rate is expected to be higher than generally anticipated, the allocation would tend toward inflation hedging and lean more toward stocks and commodities such as gold, but away from fixed-income instruments, unless they carry inflation protection (such as inflation-linked bonds). Within an asset class such as bonds, allocation would favor those in which the prices are less sensitive to the long-term effects of inflation.

If good economic growth with low inflation is expected in the stock market, the allocation would favor growth over value stocks, as this situation reduces downside uncertainty and encourages investors to place more weight on profits in the more distant future. Furthermore, small-cap stocks, on average, tend to be favored over large-cap stocks. This is because a growth-oriented situation tends to allow small-cap companies to grow at a faster rate, relative to their larger-cap counterparts.

Because the ultimate goal of asset allocation is to create a unique and customized portfolio of assets from the optimal combination of disparate investments, correlations between those asset classes must also be considered when deriving the final weights. These factors measure how diversified the constituent asset classes are and how similar asset classes perform over the investment horizon that is under consideration. Investors strive to allocate capital to create a strategic allocation in which each component has a low average correlation to another in the portfolio.

In general, the process can also be described as the optimal solution for an asset and liability problem. The liability can be defined as a scheduled cash outlay, minimum total return target, maximum sharpe ratio, a minimum tracking error (if the investment mandate is to outperform a benchmark) or some combination of the above.

2. Tactical Asset Allocation
The tactical asset allocation strategy forms a portfolio that separates it from the strategically-determined long-term, optimal portfolio. Both the opportunity and motivation arise from the market participant's independent assessment of fair value and how it differs from the market consensus. Successfully capitalizing on this strategy often requires an information advantage relative to the rest of the market. This often requires raw information as well as the superior ability to interpret that information. This is the value some investors can add through the ability to build critical relationships, and it is particularly important when the investment opportunity consists of securities in the less-developed markets, such as emerging market stocks.

SEE: What Is An Emerging Market Economy?

The implied fair value is generally derived from asset prices, using methods that can range from the fairly simple to the very intricate.

In the fixed-income asset class, especially in the shorter maturity tenors, investors measure the implied forward yield to determine how the market or consensus differs from their own in anticipating future movements in short-term interest rates.

For example, if the implied three times three forward yield (or the three-month yield, three months into the future) on a bill is lower than the level the investor expects, then, assuming the investor is correct, rather than investing in a six-month bill, it is more profitable to invest in two consecutive three-month bills. This type of analysis can be extended to longer-tenor fixed-income instruments, but with consideration given to the further complications that arise from factors, such as convexity bias.

In the equity markets, investors often reference relative valuation metrics, such as the price-to-book ratio or price-to-earnings ratio - among many others - to capitalize on short-term trading opportunities. The calculations can be used to rotate within and across asset classes.

Within the fixed-income asset class, an attractive relative valuation at the shorter end of the yield curve can be capitalized on by tactically reducing the duration exposure relative to the strategic level of duration exposure in the asset allocation.

Within equities, more compelling price-to-book ratio deviations versus price-to-earning ratio deviations can be capitalized on by tactically allocating more investments to growth stocks versus value stocks than was strategically determined. Similar types of relative comparisons can be conducted on other important valuation determinants, such as implied earnings growth for stocks.

3. Constant Weighted Allocation
A comparison of the payoff profile versus a buy-and-hold strategy (the strategic asset allocation) provides a good illustration of its properties. The buy-and-hold strategy has a linear payoff to the performance of the stock market, whereas the constant weighted allocation strategy does not.

In this strategy, the payoff is slightly concave (limited upside) as one sells into an upward market in the process of rebalancing the portfolio. This strategy is also helped by market reversals as opposed to a trending market. Volatility helps as well; when the market returns to its starting value, the strategy profits while a pure buy-and-hold yields a zero return. If the market continues to increase, however, the buy-and-hold will outperform. The payoff of this strategy is path dependent as opposed to a buy-and-hold strategy, which only depends on final value. See the comparison between constant mix and buy-and-hold strategies below.

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Figure 1

4. Insured Asset Allocation
This is a type of dynamic asset allocation strategy where the payoff is convex (limited downside) as one buys into an upward market. The strategy uses a formula-based rebalancing mechanism. Unlike the constant weighted strategy, this strategy is hurt by market reversals. A strategy that falls under this category is CPPI (constant proportion portfolio insurance) - see Figure 2 and Figure 3 below. The rules used to implement this strategy are defined by the following formulas, as illustrated for a portfolio consisting of only stocks and risk-free bills:

Buy-and-hold is a special case where the multiplier is 1.
Constant weighted allocation is a special case where the floor is 0 and the multiplier is between 0 and 1.

Stock investment = M x (Asset - Floor); M > 1
M is a multiplier which determines the amount of leverage.

As an example, with an initial portfolio of $1,000, if the floor is defined as $700 and M=2, the initial stock investment is $600.

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Figure 2

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Figure 3

Above the floor, investment is actively allocated between stocks and risk-free bills. But at or below the floor, the portfolio is fully invested in risk-free bills. Rather than actually buying stocks, the exposure can also be attained by an overlay strategy that uses derivatives such as index futures and options with the remaining capital held in risk-free bills.

The Bottom Line
Because the ultimate goal of asset allocation is to create a unique and customized portfolio of assets, you need to find the allocation strategy that suits your goals. Compare your needs with each of these techniques, and see which one will allow your portfolio to prosper and grow.

SEE: Five Things To Know About Asset Allocation

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