John Husslebee, chief executive, North Investment Partners, investigates the growing importance of asset allocation and its contribution to successful portfolio management
The UK retail investment market is changing rapidly, as an ever increasing array of asset classes and investment products become accessible to the smaller investor. Multi-asset investing is a growing discipline that will place greater demands on portfolio managers and professional investors but it needs to be embraced if the increasingly sophisticated performance demands of investors are to be met in the future.
Asset allocation is an increasingly important contributor to overall risk-adjusted investment portfolio returns. It is probably more important now than it has ever been before. The percentage weightings allocated across various asset classes have always determined the long-term returns of a portfolio and the levels of volatility experienced along the way. Research is continually concluding that market timing and stock selection contribute only a relatively small amount to performance in comparison.
Gaining a better understanding of what an asset class actually is, offers a clearer picture as to why this is such an important discipline to embrace and why it has such an enormous impact on the overall risk-adjusted returns of an investment portfolio. Diversification, the core principle of any investment portfolio, means so much more than just multiple investments.
An asset class can be defined as &a group of investments that display similar characteristics&. They tend to share similar risk and return profiles, and display similar price behaviour as their fortunes move in sync with each other through the cyclical swings of normal global economic activity. In fund management parlance these investments are referred to as displaying positive correlation. For the portfolio manager, positive correlation is not a good thing. Risk is reduced and diversification achieved by investing in asset classes that display negative correlation. It is often better to concentrate your efforts on the things you can control, in this case risk, rather than the things you can't, such as timing economic cycles.
Different asset classes display varying levels of correlation. Bonds perform well in low inflationary environments and economic downturns. Commodities perform in overheating economies and equities perform in growing economies. Put simply, asset classes perform differently in different market conditions.
The traditional asset classes used by most investors have historically been cash, fixed income and domestic equities. Within the latter two asset classes, further diversification can be achieved through short term, long term, high yield, convertible and corporate, in the case of bonds, and large cap, mid cap, small cap, value and growth in the case of equities. In both cases, an investor can diversify even further by investing in international markets.
Historically, global stockmarkets tended to display lower levels of correlation to each other than they currently do, and it was enough to further diversify your portfolio through overseas equities and debt instruments. But in the wake of increasing globalisation we are seeing much greater levels of correlation between global markets. Global equities on a regional basis are starting to move as one. Companies and industries are more globally orientated now and there is a strong argument that diversification can be better achieved through industry sector rather than global region. For portfolio managers, negatively-correlated assets have to be found elsewhere to ensure a well-diversified portfolio. Equities, bonds and cash are simply not enough anymore.
There have always been plenty of other, less correlated asset classes to look at but they have only become accessible to smaller sums of capital in recent years. New products such as exchange traded funds, covered warrants, Reits, commodity funds and funds of hedge funds have all added to the toolbox.
Now investors of all sizes can use these retail products to access a broader range of assets embracing property, venture capital, structured products, hedge funds, commodities, such as gold and oil, and derivative instruments. And with the regulatory changes in effect through COLL, the new FSA rulebook, fund of funds providers are able to embrace the majority of these additional asset classes and offer off-the-shelf multi-asset funds. We have entered the realm of the truly multi-asset portfolio.
Successful asset allocation involves finding the optimum combination and exposure of complementary investments. This necessarily involves a high element of research, analysis and risk control. And it hardly needs pointing out that the greater the range of asset classes, the greater the level of knowledge, research and analysis is required. For those looking to manage portfolios themselves, this will necessitate a greater resource than probably used at the moment. For the casual investor, there are a limited number of multi-asset fund of funds portfolios around but I am sure this is set to grow over the coming months and years.
However, multiple asset class strategies should be more than just passive exposure to the broad range of asset classes now available. Simply throwing a bit of hedge fund, property and commodities into the mix is not going to be enough in this more sophisticated and demanding market place. Dynamic asset allocation is going to be the main driver of portfolio outperformance over the coming years.
The introduction of multi-asset strategies will broaden what is achievable in terms of performance and investment objectives. The opportunity for downside protection and performance in a wider variety of market conditions is only the tip of the iceberg in terms of what is possible. But even the most dynamic of asset allocation implementation policies will not capture 100% of the upside of any particular asset class, theme or market. Despite the ever-evolving world of portfolio management the principles are still the same. The right blend of non-correlated or low correlated assets ensures a smoother ride over the long term.
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