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Investment - Asset Allocation and Portfolio Construction
After generating the investment policy statement (IPS), which comprises — among other facts — an investor’s desire and ability to take risk, the asset allocation of the portfolio is defined.
This determination entails decisions regarding whether asset classes are suitable (e.g., global stocks, domestic government bonds, commodities, or domestic real estate investment trusts) and the proportion of the portfolio to invest in each asset class. In some circumstances, the asset distribution decision is documented as part of the IPS; in other cases, asset allocation is recognized as part of the following execution of the IPS.
The chosen strategic asset allocation is intended to match the investor’s long-term risk and return objectives. An investor may determine the strategic asset allocation and simply keep a portfolio for the life of the investment. If the investor does so, the proportions of the portfolio will likely vary from the original weights specified because the different asset classes provide different rates of return over time and their values thus increase or fall by different amounts. As a result, the portfolio has to be changed through a process called rebalancing.
Rebalancing entails selling some of the assets that have increased as a proportion of the portfolio and putting the proceeds into the holdings that have declined as a proportion of the portfolio. Because there are trading costs connected with rebalancing, most investors will not rebalance on a continuing basis, but will instead rebalance at specified intervals or weightings.
Tactical Asset Allocation
Although the chosen strategic asset allocation is expected to match the investor’s objectives over the long term, there are instances when shorter-term changes in asset class returns can be utilized to potentially boost portfolio returns. A short-term change among asset classes is known as tactical asset allocation.
Strategic Asset Allocation
Strategic asset allocation is the long-term mix of assets that is expected to suit the investor’s objectives. The desired overall risk and return profile of the portfolio is a consideration in selecting the strategic asset allocation. A portfolio with a strategic asset allocation dominated by stocks would be expected to have a greater return and be more volatile than a portfolio dominated by bonds because bonds normally have lower risk than equities and so provide lower returns. The strategic asset allocation that is suitable for one investor may not be suitable for another.
Academic research have revealed that strategic asset selection considerably affects the average return of a portfolio. Thus, asset allocation demands considerable attention from investors, investment managers, and investment counselors. Consider the following example of strategic asset allocation.
Example: Strategic Asset Allocation
An institutional investor requires a 7% return on its investments. The investing committee decides to invest in global equities and in European government bonds. At the time the investment is made, European government bonds are yielding 4%, and the committee’s projection for the long-term return on the global equities market is 9%.
A portfolio allocation of 40% bonds and 60% equity generates an estimated return of 7%: (0.40 × 0.04) + (0.60 × 0.09) = 0.07 or 7%
The committee has to examine the level of risk suggested by this asset allocation. If the committee is not comfortable with the risk, the return criterion may need to be adjusted. The portfolio composition can be modified as bond yields vary and the committee revises its forecasts for the return on the global equity.
Strategic asset allocation often involves investment managers to evaluate the projected risk and return of each asset type. Historical returns can be used as a guide, but forecasts need to be forward-looking. Managers also need to establish the correlation of returns between the asset classes so they can quantify the diversification benefits that may be realized by combining the various assets in a portfolio.
To illustrate, we will extend the preceding scenario in which an investor has a strategic asset allocation of 60% global equities and 40% European government bonds. The investment manager may think the global equities market is overvalued and likely to provide bad returns in the short run. In response, the manager could modify the asset allocation to, for example, 50% equities and 50% bonds. If the manager’s forecast is true, this 50/50 tactical allocation will perform better in the near term than the strategic asset allocation of 60/40. The management will have added return for the investment compared with maintaining the strategic weights on a static basis.
But anticipating markets is tough, and tactical allocation does not always favor the investor. The difficulty of financial forecasting means investors may prefer to retain their strategic asset allocation within established parameters. For example, an appropriate strategic asset allocation may be judged to be 56%–64% global stocks and 36%–44% European government bonds, rather than 60% global equities and 40% European government bonds. Such ranges allow for some tactical asset allocation and lessen the need for and expense of frequent portfolio rebalance.
An investor or manager often employs a range of tools and information to make tactical allocation decisions. The decisions may be based on one of the following:
Fundamental studies of economic and political factors and their probable effects on market returns
Market value measures relative to prior data
Trends and momentum in marketplaces
When considering tactically adjusting a portfolio’s asset allocation, a manager may look at the strength of the economy and expected future trends to acquire a view on how the central bank might change interest rates and on what might happen to company profits. The manager may next look at the level of the price-to-earnings ratio of the stock market and how it compares with recent decades as a measure of valuation or with the level of bond yields relative to historical ranges. The management could also look at stock and bond market patterns as a way of measuring investor mood.
Tactical asset allocation represents an attempt to enhance value to a portfolio by departing from the strategic asset allocation. Tactical asset allocation is a form of active portfolio management.
After generating the investment policy statement (IPS), which comprises — among other facts — an investor’s desire and ability to take risk, the asset allocation of the portfolio is defined.
This determination entails decisions regarding whether asset classes are suitable (e.g., global stocks, domestic government bonds, commodities, or domestic real estate investment trusts) and the proportion of the portfolio to invest in each asset class. In some circumstances, the asset distribution decision is documented as part of the IPS; in other cases, asset allocation is recognized as part of the following execution of the IPS.
The chosen strategic asset allocation is intended to match the investor’s long-term risk and return objectives. An investor may determine the strategic asset allocation and simply keep a portfolio for the life of the investment. If the investor does so, the proportions of the portfolio will likely vary from the original weights specified because the different asset classes provide different rates of return over time and their values thus increase or fall by different amounts. As a result, the portfolio has to be changed through a process called rebalancing.
Rebalancing entails selling some of the assets that have increased as a proportion of the portfolio and putting the proceeds into the holdings that have declined as a proportion of the portfolio. Because there are trading costs connected with rebalancing, most investors will not rebalance on a continuing basis, but will instead rebalance at specified intervals or weightings.
Tactical Asset Allocation
Although the chosen strategic asset allocation is expected to match the investor’s objectives over the long term, there are instances when shorter-term changes in asset class returns can be utilized to potentially boost portfolio returns. A short-term change among asset classes is known as tactical asset allocation.
Strategic Asset Allocation
Strategic asset allocation is the long-term mix of assets that is expected to suit the investor’s objectives. The desired overall risk and return profile of the portfolio is a consideration in selecting the strategic asset allocation. A portfolio with a strategic asset allocation dominated by stocks would be expected to have a greater return and be more volatile than a portfolio dominated by bonds because bonds normally have lower risk than equities and so provide lower returns. The strategic asset allocation that is suitable for one investor may not be suitable for another.
Academic research have revealed that strategic asset selection considerably affects the average return of a portfolio. Thus, asset allocation demands considerable attention from investors, investment managers, and investment counselors. Consider the following example of strategic asset allocation.
Example: Strategic Asset Allocation
An institutional investor requires a 7% return on its investments. The investing committee decides to invest in global equities and in European government bonds. At the time the investment is made, European government bonds are yielding 4%, and the committee’s projection for the long-term return on the global equities market is 9%.
A portfolio allocation of 40% bonds and 60% equity generates an estimated return of 7%: (0.40 × 0.04) + (0.60 × 0.09) = 0.07 or 7%
The committee has to examine the level of risk suggested by this asset allocation. If the committee is not comfortable with the risk, the return criterion may need to be adjusted. The portfolio composition can be modified as bond yields vary and the committee revises its forecasts for the return on the global equity.
Strategic asset allocation often involves investment managers to evaluate the projected risk and return of each asset type. Historical returns can be used as a guide, but forecasts need to be forward-looking. Managers also need to establish the correlation of returns between the asset classes so they can quantify the diversification benefits that may be realized by combining the various assets in a portfolio.
To illustrate, we will extend the preceding scenario in which an investor has a strategic asset allocation of 60% global equities and 40% European government bonds. The investment manager may think the global equities market is overvalued and likely to provide bad returns in the short run. In response, the manager could modify the asset allocation to, for example, 50% equities and 50% bonds. If the manager’s forecast is true, this 50/50 tactical allocation will perform better in the near term than the strategic asset allocation of 60/40. The management will have added return for the investment compared with maintaining the strategic weights on a static basis.
But anticipating markets is tough, and tactical allocation does not always favor the investor. The difficulty of financial forecasting means investors may prefer to retain their strategic asset allocation within established parameters. For example, an appropriate strategic asset allocation may be judged to be 56%–64% global stocks and 36%–44% European government bonds, rather than 60% global equities and 40% European government bonds. Such ranges allow for some tactical asset allocation and lessen the need for and expense of frequent portfolio rebalance.
An investor or manager often employs a range of tools and information to make tactical allocation decisions. The decisions may be based on one of the following:
Fundamental studies of economic and political factors and their probable effects on market returns
Market value measures relative to prior data
Trends and momentum in marketplaces
When considering tactically adjusting a portfolio’s asset allocation, a manager may look at the strength of the economy and expected future trends to acquire a view on how the central bank might change interest rates and on what might happen to company profits. The manager may next look at the level of the price-to-earnings ratio of the stock market and how it compares with recent decades as a measure of valuation or with the level of bond yields relative to historical ranges. The management could also look at stock and bond market patterns as a way of measuring investor mood.
Tactical asset allocation represents an attempt to enhance value to a portfolio by departing from the strategic asset allocation. Tactical asset allocation is a form of active portfolio management.
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