Strategic Asset Allocation

Strategic Asset Allocation is an approach towards portfolio construction. It helps determine the allocation to asset classes considered for investment. The tolerance for risk and expectations of return are crucial in determining the optimal Strategic Asset Allocation for an investor. These, along with the investment horizon, are vital in shaping the allocation of a portfolio over time.

As opposed to Tactical Asset Allocation, which targets a short or medium-term investment horizon, Strategic Asset Allocation is a long-term decision, typically spanning a decade or more.

The asset classes are divided across levels, market caps and geographically. Broadly speaking, the three major asset classes are equities, fixed income, and cash. But they can be further subdivided. For instance, the overall allocation to equities can be divided across large, medium and small-cap stocks, or across geographies like Asia-Pacific and Latin America, or country-specific allocations to the US, the United Kingdom, Japan, among others. Analytical classifications like developed, emerging, and frontier markets can also be used to allocate the equity or fixed income portion of the portfolio.

Strategic Asset Allocation is based on Modern Portfolio Theory. Let’s briefly look at this basis and the relationship between the two.

Strategic Asset Allocation

Modern Portfolio Theory and Strategic Asset Allocation

Modern Portfolio Theory puts forth the hypothesis that investors can create portfolios which provide them maximum or optimum returns for a given level of risk. It also extolls the virtues of diversification, i.e. spreading a portfolio across asset classes as well as instruments.

Strategic Asset Allocation uses Modern Portfolio Theory as a base by making use of the efficiency of markets. It does so by determining an asset allocation, based on risk tolerance, and then sticking to it, instead of trying to assess the direction of markets. This discipline is the cornerstone of the Strategic Asset Allocation approach.

Strategic Asset Allocation Process

Assessment of Risk

The Strategic Asset Allocation process begins with the assessment of the risk tolerance level of an investor. This is done in a detailed manner with the help of questionnaires as well as via discussions between the investor and the entity constructing the portfolio.

Investment Horizon

Another key input is the investment horizon, i.e. the duration for which an investor intends to keep the money invested in the portfolio.

These two inputs are key in determining the eventual portfolio and are used in tandem. For an investor who has a high level of risk tolerance, a higher exposure to equities may not necessarily be the optimal choice unless the time-frame of investment is also known. Thus, for a high-risk investor with a short-term time horizon, a more moderate equity exposure would be suggested compared to another investor who has a similar tolerance for risk but a relatively longer time-frame to remain invested.

Broad-Based Asset Allocation

After assessing an investor’s risk profile and discussing the investment horizon, an allocation to broad-based asset classes like equities, fixed income, and cash is made keeping in mind the expected return of these asset classes given their levels of risk.

Further Allocation in Each Broad Based Asset Classes

This step is followed by further breaking down these broad asset classes into categories divided into market capitalization groups, by geographical divisions, or by analytical groups or any other method. Similar to the broad-based asset classes, percentage allocation to these categories follows the next step.

Monitoring and Rebalancing

After the Strategic Asset Allocation is determined, it is monitored and rebalanced on a particular frequency like bi-annually or annually.

Let’s see how this works by an example.

Rebalancing in the Strategic Asset Allocation Process

Though Strategic Asset Allocation is akin to a buy and holds strategy, this is not to say that it is not monitored. Portfolio rebalancing ensures that after a pre-determined period, the entity managing the portfolio makes changes to the allocation in order to ensure that the allocation to the broad asset classes, namely, equities, fixed income, and cash, is brought back to the level which was determined initially. This is required because the returns from these asset classes change the asset allocation, given their performance over the course of the period.

Example of Rebalancing

Initial Investment

For instance, let’s consider an investor with $100,000 to invest. According to his risk tolerance level and investment horizon assessment, let’s assume that the Strategic Asset Allocation comes out to be 60% to equities, 30% to fixed income, and 10% to cash. This means that $60,000 of the aforementioned investment pool will be invested in stocks, $30,000 will be invested in bonds, and $10,000 will be invested in cash and cash equivalents. The rebalancing frequency has been fixed as annually.

Rebalancing

After one year, let’s assume that the equities portion of the portfolio has returned 20%, fixed income has returned 9.5% and cash has returned 2.5%. This performance has increased the overall value of the portfolio to $115,100 with the value of equities, fixed income, and cash segments standing at $72,000, $32,850, and $10,250 respectively. But due to this change in value, the allocation of these asset classes now stands at 62.6%, 28.5%, and 8.9% respectively, which is a deviation from the 60:30:10 mix that was determined initially.

New Status

According to the initial asset allocation mix, the value of the equities segment should be $69,060, that of fixed income should be $34,530, and that of cash should be $11,510 given the new value of the overall portfolio. This means that $2,940 from the equities segment needs to be sold off and the proceeds need to be used to buy $1,680 worth of bonds with the remaining $1,260 being invested in cash and cash equivalents.

Conclusion

In this manner, rebalancing compels the investor to book profits from the segments which are doing well and redeploy to other asset classes.

Given the effectiveness of the diversification of portfolio, and the discipline that comes with investing in the Strategic Asset Allocation strategy, an investor can reap the benefits of relatively low correlation between broad asset classes as well as securities comprising these asset classes, as over long period s of time, no particular asset class is expected to outperform the others consistently.

References:

Last updated on : January 22nd, 2018
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