Strategic asset allocation

The primary goal of portfolio management is to maximize your return for the risk you are willing to take. Sounds pretty straightforward, doesn't it? The trick is to find the proper balance in your portfolio to achieve this objective. Highly debated and much studied, this strategy is known as asset allocation.

Is asset allocation important to your portfolio? A landmark study by Brinson, Hood and Beebower in 1986, and a follow-up completed in 1991, attributed the variability of returns in a sample of over 90 large U.S. pension plans to three different decisions: asset allocation, market timing, and security selection. They found that over 90 per cent of return variability was explained by a fund's asset allocation, that is, the way asset classes were combined. Clearly, over time, asset allocation decisions say more about how a typical portfolio performs than any other investment decision. However, most investors spend most of their time in market timing and security selection instead of maintaining proper asset allocation.

What is asset allocation? It refers to a particular mix of stocks, bonds, cash, and potentially other asset classes that make up your portfolio.

Strategic Asset Allocation

Strategic asset allocation is an investment theory based on the principles of the Nobel-prize-winning dissertation of Modern Portfolio Theory. When a portfolio is created, a base policy mix is established, founded on expected returns and risk. Then the asset class mixes are rebalanced to target weights according to the original mix, usually at regular intervals such as monthly or quarterly, to maintain a long-term goal for asset allocation.

In other words, the portfolio manager does not attempt to deviate from the original determined weights in order to add value. The emphasis is on preserving the fixed weights because they ultimately relate to a larger performance objective.

Once your portfolio weighting has been set, you choose appropriate money managers for each mandate (e.g., large cap international equities with a value investing style), which adds value to the long-term returns on their objective.

Pros

Strategic is appropriate for investors who want an investment mix that does not change with the markets, and strive to rebalance by buying when prices are low and selling when prices rise. They know what the allocation to assets was at the beginning and want to maintain that mix through all market conditions. Strategic is suitable for long-term investors who do not want to waste time and energy trying to time markets or make specific security selection.

Strategic asset allocation is based on long-term trends and is appropriate for investors who like to sleep at night, knowing that in the long run their portfolio matches their risk tolerance and will achieve their long-term goals. In other words, it is an unexciting yet highly effective strategy for the greater part of your portfolio.

Cons

Strategic asset allocation will never shoot the lights out, as it is structured to obtain a specific return for a particular risk over a market cycle (generally defined as six to eight years). Strategic asset allocation does not allow for anomalies in the market place and as a result, can underperform the markets on a regular basis.

Although not really a con, this aspect can certainly be seen as a negative. For example, when technology stocks soared, everyone (including the experts) offered statistics depicting how obvious this phenomenon was and how valuation methods for stocks did not apply to technology stocks. As a result, some clients abandoned strategic asset allocation and started to deviate with a much larger weighting in this sector.

Everything was fine until someone used a calculator and determined that it made no sense to pay 200 times earnings for a company. Consequently, the bottom fell out of the market. Investors lost a substantial portion of their assets and claimed that they would never do that again.

Today's picture

We are currently seeing an anomaly that seems obvious in hindsight, and is believed likely to continue for the foreseeable future. Of course, the Canadian dollar has experienced a massive increase over the US dollar, primarily because of greater demand for resources. This trend cannot continue (after all, commoditization cannot go on forever). This seems so apparent that investors are starting to abandon their strategic asset allocation strategies of diversified asset classes, geographic sectors and management styles and to focus on these new areas of growth because, in the short run, these approaches have not been paying off.

Unfortunately, over the last 20 years, we have seen everything continually revert to the mean. The dollar will come back down (we just don't know when), the market will decrease (we just don't know when) and the U.S. market will climb (we just don't know when). When these occur, you may have abandoned a perfectly good portfolio strategy to pursue a sector strategy that is far beyond your risk level. If it fails, it will fail big time.

Stay the course

Our advice is always the same. We know that it is preferable to be in a diverse set of asset classes, geographical locations, market capitalization and styles of management. Retaining the best managers in each category will add value to the long-term performance of each mandate. It simply takes time. You may not feel you have time, but you do have a choice - play the return game (buy and sell repeatedly based on performance) or do the right thing.

Deciding upon an investment plan and sticking to it can be compared to setting a course when starting on a long journey. You adjust your route only when conditions change.

If you would like to review your current asset allocation strategy, as well as your investment manager selection process, please call our office for an appointment.