Asset allocation and some of its various forms

Patrick Norwood, Insight Analyst (Funds)

Asset allocation is a strategy that attempts to maximise return for a given level of risk, or minimise risk for a given level of return, by adjusting the proportion of each asset class in the portfolio according to the investor’s objectives, risk tolerance, time frame and any other constraints. Asset classes include UK equities, equities from other parts of the world, government bonds, corporate bonds, property and cash. Often ‘alternative’ asset classes such as hedge funds, private equity and commodities will be in the portfolio too. 

The principal behind asset allocation is based on Modern Portfolio Theory - that the returns of the asset classes are not perfectly correlated and different asset classes will do better at different points, depending on the prevailing market and economic conditions. 

With strategic asset allocation (SAA), the aim is to create an asset mix that will provide the optimal balance between risk and return over the long-term, usually several years. This will normally be done through mean variance optimisation (MVO) or some variation of it. With MVO, the asset mix which gives the highest portfolio return for a given level of risk, or the lowest total risk for a given level of return, is sought after. 

This requires assumptions to be made for the future return and risk of each asset class plus their expected relationships with each other and this is one of the main problems with MVO. These assumptions might be based on how the asset classes have behaved in the past; however, there is no guarantee that past behaviour and relationships will continue in the future, as investors have found to their cost in recent years. An alternative is to be more qualitative with the inputs, but one is then relying on the subjective opinion of the provider. Often a mix of the two methods is used - starting with past numbers and relationships and then adjusting these qualitatively if/where necessary. 

The portfolio will be periodically rebalanced back to the initial SAA as the relative allocations of the asset classes will change with the passage of time, due to their differing returns. Although changes to the SAA can and will take place, these will normally be fairly infrequent. In other words, it is assumed that the investor’s above parameters will remain fairly stable over time and the SAA should only be changed when there has been a significant shift in either the investor’s objectives and risk tolerance or the asset allocation inputs described in the last paragraph. 

Tactical asset allocation (TAA) is where the fund manager attempts to increase the return of the portfolio by moving slightly away from the above SAA if they see any short-term opportunities. For example, if the manager believes that European equities are very undervalued compared to the relative valuations of the other asset classes in the portfolio they would increase the weighting of European equities above its SAA weight, possibly through the use of derivatives. As a result, one or more of the other asset classes in the portfolio would have to be below its SAA weight so that the total percentage still adds up to 100. TAA positions are normally based on 3 to 12 month views. 

As with other forms of active management, there is the risk that the manager’s view is incorrect, resulting in underperformance (relative to the SAA). Plus there may be additional trading costs involved with TAA, although less so if derivatives are used to implement the position. 

A variant on the above is global tactical asset allocation (GTAA). The difference between GTAA and TAA is that TAA is restricted to the asset classes in the original SAA, whereas with GTAA a broader opportunity set can be accessed, normally other equity, bond and currency markets from around the world.