How to do strategic and tactical asset allocations to get more profit?

Financial Planning | admin | October 10, 2011 at 6:50 am

The unpredictable behaviour of the markets has left many clients I have been meeting confused about where to invest: equities, bonds, gold or real estate? They wonder how they will achieve their long-term investment objectives amidst all this volatility.

In 2011, the Indian equity markets have been among the worst-performing globally, while gold has seen a spectacular rise.

So should investors stop putting money in equities and move their assets to gold? The answer is no. They should maintain a combination of the two, based on a clear sense of their investment objectives, following a disciplined asset-allocation approach.

From early on in our lives, we have been taught to not put all our eggs in one basket. It is no different in the investment world. It is well understood now that different categories of assets behave differently, and making allocation across asset classes helps optimise returns and reduce risk in a portfolio.

What is Asset Allocation?: The role of a wealth manager is to manage clients' investment portfolios to help them achieve their longer-term objectives while staying within a defined risk or volatility framework. To achieve this, the portfolio manager diversifies a client's funds across different asset categories, including stocks, bonds, cash, and alternative assets such as commodities and real estate. This process is called asset allocation and the approach applies to all types of investors and investment corpuses, HNI and retail alike. There is an oft quoted study of 1986 by Gary Brinson, Randolf Hood & Gilbert Beebower (BHB), which indicates that asset-allocation decisions contribute to 90% of the performance of an investment portfolio.

To put the above principle into practice, a framework for asset allocation has been developed over time, which has two main components – strategic asset allocation and tactical asset allocation.

Strategic asset allocation is a proportional combination of asset classes based on an investor's risk appetite, expectation of returns and investing time frame, taking into account the expected rate of return and volatility of each asset class. For example, a portfolio that has an equal or near-equal exposure to equities and bonds is known as a balanced portfolio.

Tactical asset allocation is a term used for the ongoing adjustments made to this allocation based on shorter term views for different asset classes. In an overarching asset-allocation framework, tactical allocation involves the active management of a portfolio in line with the house view by taking shorter-term overweight or underweight positions in asset classes to reflect the expected outperformance of those over that term. This flexibility adds an element of market timing to the portfolio, allowing an investor to participate in economic conditions that are more favorable for one asset class than for others. This approach requires regular re-balancing of the portfolio. For this, one must be able to recognise where short-term opportunities exist as also when those opportunities have run their course. In practice, it requires periodic re-balancing of the portfolio towards the long-term strategic position.

Let's take an example. In general, equities tend to be volatile over shorter periods but deliver significant outperformance over a longer time frame, while bonds tend to display lower volatility and give lower returns. So, if equities have historically returned 15% per year and bonds have returned 10% per year, a mix of 50% stocks and 50% bonds in a regularly re-balanced portfolio would be expected to return 12.5% per year over the longer term, and with lower volatility than a pure equity portfolio.

Therefore, 50:50 is the strategic asset allocation of the portfolio. There could be periods when the tactical asset allocation position of this portfolio may reflect a 40% allocation to equities and a 60% allocation to bonds and vice versa. To look at an example in the recent past, an active portfolio manager would have reduced his exposure to equities when the valuations were looking stretched during the market peaks of 2007. However, without the tactical overlay, one would have maintained the same strategic allocation, irrespective of how expensive the markets were. Subsequently, the same portfolio manager would have gradually increased his exposure as the Sensex fell below the 10,000 levels, creating significant outperformance when compared with the benchmark.

Conclusion: In summary, the process of strategic asset allocation is critical to identifying the correct mix of asset classes based on the return objectives and risk tolerance of an investor and, if implemented correctly, tactical asset allocation can contribute meaningfully to the overall outperformance of the investment portfolio by identifying and impl- ementing shorter-term investment opportunities within the portfolio.

Source: Economic Times

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