9.5 Asset Allocation

Asset allocation - dividing investments among different asset classes - is widely considered the most important investment decision. Research suggests it accounts for the majority of portfolio return variability.

Why Asset Allocation Matters

A landmark study by Brinson, Hood, and Beebower found that approximately 90% of portfolio return variability is explained by asset allocation policy, not security selection or market timing.

- Asset Allocation Policy: about 90%

- Security Selection: about 5%

- Market Timing: about 2%

- Other Factors: about 3%

Major Asset Classes

Traditional Asset Classes

- Equities (Stocks): Higher return potential, higher risk; Role in Portfolio: Growth

- Fixed Income (Bonds): Lower return, lower risk, income; Role in Portfolio: Stability, income

- Cash/Money Market: Lowest return, highest liquidity; Role in Portfolio: Safety, liquidity

Alternative Asset Classes

- Real Estate (REITs): Income + growth, inflation hedge; Correlation to Stocks: Moderate

- Commodities: Inflation hedge, uncorrelated; Correlation to Stocks: Low to moderate

- Private Equity: High return potential, illiquid; Correlation to Stocks: Varies

- Hedge Funds: Absolute return strategies; Correlation to Stocks: Low (if managed well)

Sub-Asset Classes

- Equities: Large cap, mid cap, small cap; growth vs. value; domestic vs. international; developed vs. emerging

- Fixed Income: Government, corporate, municipal; investment grade vs. high yield; short, intermediate, long duration

Types of Asset Allocation

Strategic Asset Allocation (SAA)

Definition: Long-term, policy-based allocation based on client profile and goals.

- Time Horizon: Long-term (years)

- Approach: "Buy and hold" with periodic rebalancing

- Based On: Client risk tolerance, time horizon, goals

- Changes: Only when client circumstances change

- Goal: Match allocation to client's investment policy

Example: A moderate investor might have a strategic allocation of:

- 60% Stocks

- 35% Bonds

- 5% Cash

Tactical Asset Allocation (TAA)

Definition: Short-term deviations from strategic targets based on market conditions.

- Time Horizon: Short-term (months)

- Approach: Active adjustments based on market views

- Based On: Market valuations, economic outlook

- Changes: Frequent, within defined ranges

- Goal: Add value through market timing

Example: If the market appears overvalued, a tactical manager might temporarily shift from the strategic 60% equity to 50% equity.

Comparing SAA and TAA

- Philosophy: Strategic: Markets are efficient; Tactical: Markets can be timed

- Trading: Strategic: Minimal (rebalancing only); Tactical: More frequent

- Costs: Strategic: Lower; Tactical: Higher

- Skill Required: Strategic: Lower; Tactical: Requires forecasting ability

- Evidence: Strategic: Generally supported; Tactical: Mixed results

Dynamic Asset Allocation

Definition: Continuous adjustments based on market conditions, often contrarian.

- Approach: Systematically adjust allocation as markets move

- Example Rule: Reduce equity exposure as market rises

- Nature: Often contrarian (buy low, sell high)

- Implementation: Can be formula-based

Constant-Proportion Portfolio Insurance (CPPI)

Definition: Formula-based strategy that maintains a floor value while adjusting equity exposure.

- Portfolio rises: Increase equity exposure

- Portfolio falls: Decrease equity exposure

Goal: Protect against downside while participating in upside.

Rebalancing

Purpose of Rebalancing

Rebalancing returns a portfolio to its target allocation after market movements cause drift.

- Risk Control: Prevents portfolio from becoming too aggressive or conservative

- Discipline: Systematically "buy low, sell high"

- Alignment: Keeps portfolio consistent with investment policy

Rebalancing Approaches

- Calendar: Rebalance at fixed intervals (quarterly, annually); Pros: Simple, predictable; Cons: May not capture large drifts

- Percentage: Rebalance when allocation drifts by X% (e.g., 5%); Pros: Responsive to market; Cons: Requires monitoring

- Combination: Both calendar and percentage triggers; Pros: Balanced approach; Cons: More complex

Example: If target is 60% stocks and actual allocation drifts to 70% stocks after a rally, rebalancing would sell stocks (high) and buy bonds (relatively low).

Rebalancing Considerations

- Transaction Costs: Frequent rebalancing incurs trading costs

- Tax Impact: Selling winners may trigger capital gains

- Account Type: Tax-deferred accounts avoid tax impact

- Timing: More frequent isn't always better

Asset Allocation Process

Steps for Advisers

1. Gather client information (risk tolerance, time horizon, goals)

2. Determine strategic allocation based on client profile

3. Select specific investments within each asset class

4. Implement the portfolio

5. Monitor and rebalance as needed

6. Review periodically and adjust for life changes

In Practice

Common allocation guidelines (rules of thumb, not absolute rules):

- Aggressive: Stocks 80-100%, Bonds 0-20%, Cash 0-5%

- Moderate Growth: Stocks 60-80%, Bonds 20-35%, Cash 0-5%

- Moderate: Stocks 40-60%, Bonds 35-55%, Cash 5-10%

- Conservative: Stocks 20-40%, Bonds 50-70%, Cash 10-20%

On the Exam

Series 65 frequently tests:

- Distinguishing strategic (long-term) from tactical (short-term) allocation

- Understanding the purpose of rebalancing

- Knowing asset allocation is the primary driver of returns

- Recognizing that rebalancing systematically "buys low, sells high"

Key Takeaways

1. Asset allocation accounts for about 90% of portfolio return variability

2. Strategic allocation is long-term, based on client profile

3. Tactical allocation involves short-term deviations based on market views

4. Rebalancing maintains target allocation and controls risk

5. Rebalancing systematically "buys low, sells high"

6. Consider transaction costs and taxes when rebalancing