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Having gone through the basics of Asset Allocation and further understating the Strategic & Tactical approach to asset allocation let's try to understand more about their application.
Strategic asset allocation
Strategic asset allocation is the traditional approach to building a portfolio. As we discussed in my last article after evaluating the risk profile & understanding the financial circumstances of an individual a fixed set of distribution of investible corpus between the various asset classes is derived. Accordingly weightings are allocated to each asset class. The investible surplus is then distributed basis the given asset weight to each asset class and then this is compared at a pre-specified time or frequency. Any deviation to the asset weight, which happens due to performance of respective asset class during that period, is corrected by re-balancing the portfolio allocation. So, essentially in this strategy the advisor requires a great deal of analytics & risk assessment tools to arrive at the most suitable asset allocation for their client at the beginning. Once asset weights are assigned then the advisor's main job is to follow the discipline of periodic review & portfolio re-balancing as per the suggested weights. Any additional investments too need to be invested in a way that the strategic asset allocation is not disturbed. It's important to note that market view or liking to any particular asset class has little or no room to play in this strategy.
Such strategy works very well in a long period of time. It entails a buy & hold principle at all times because portfolio changes are done at periodic interval or if any additional purchase/re-purchase has to be processed. This strategy is more scientific in nature & does not allow any room for emotions. So typically in a rising equity market the advisor will be constantly selling equities & buying debt thereby reducing the portfolio risk all along as well as protecting portfolio earnings periodically too and vice-a-versa. Typically a one sided secular market move can also be very frustrating for the advisor because invariably the advisor would have started adding or reducing to a particular asset class much earlier. But at the same time when the tides turn the advisor would look much smart than the rest.
Given the simple application it allows an advisor to cater to a larger set of clients. The advisor may choose to form various categories of risk seeker and design their respective asset allocation at the first place. Further clients could be assigned to one of these categories and thereby their asset allocation could be derived. So, instead of now managing asset allocation at the client level the advisor can track asset allocation for the respective category. Any changes to the category could then be applied to all clients falling under that category.
Tactical asset allocation
Tactical asset allocation as we discussed in my earlier article gives an advisor a broad range within which asset weights could be assigned given the risk reward offered by different asset classes and view. The general principal applied to arrive at tactical asset weights is the efficient frontier portfolio management theory. So typically each asset class is assessed on the basis of their performance & risk (standard deviation) for various time periods. Then correlation & covariance amongst these asset classes is derived. Using MS - Excel based application portfolio risk & return could then be derived for various combination of asset mix. This involves a great deal of statistical & mathematical calculations. From out of these many portfolio asset weight combinations the one with optimum return with lowest standard deviation is selected. This is what is known as efficient frontier. For a given quantity of risk what essentially could be the best possible asset allocation. This strategy is therefore designed specifically for each investor & requires a great deal of research & calculations. So could we have a more practical application? The answer is yes.
In my view strategic asset allocation should be the first step towards arriving at a tactical asset allocation. Asset weights & client categorization process to be the same. Past performance of each asset class on the basis of risk & return both should be studied and a long term average could then be ascertained. Using the long term average portfolio risk & expected return for each category of investor can then be calculated. This becomes the basic reference point for asset allocation decision going forward. Now, portfolio risk & expected return could be calculated as per current portfolio performance. This should then be compared with the long term average of portfolio risk & expected return. Deviation if any could then be resolved by adjusting the asset weights in order to arrive at the same quantum of portfolio risk as suggested by the long term average one for the most optimum expected return.
Asset weights derived by this exercise will be different from the ones suggested as per strategic asset allocation. The deviation can then be corrected across the client portfolios. Further, view upon a particular asset class could play an important role in this theory. Notwithstanding the asset class mix suggested by the tactical asset allocation one may choose to increase or decrease the portfolio allocation given the view on a particular asset class. For example even for a very aggressive investor theoretically a 100% weight on a single asset class say equities can never be derived by applying any of these theories. Let's suppose the general market condition looks good, valuations looks compelling & markets have corrected more than 15% then an aggressive investor may want to increase his weight to equities to 100%, purely a tactical opportunistic call. In this case the asset weights could well be adjusted to suit his requirement.
Also in many circumstances investors share only a part of their portfolio with their advisors while they may be invested differently with other advisors or in different asset classes directly. In such a scenario the advisor needs to take into account these facts & modify the tactical asset weights to incorporate a better reflection of suitable asset class in their clients overall portfolio. The same should be communicated & agreed upon with the client at the first place.
We will discuss some of the real life experiences &more pragmatic approach to practice the discipline in my last & concluding series next week.
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