Uncovering the world of Asset Allocation Like A Pro

  • Feb 13, 2020 AEDT
  • Team Kalkine
Uncovering the world of Asset Allocation Like A Pro

Have you counted yourself in?

When we talk about asset allocation, the first thing which comes to our mind is what our balance sheet really looks like! As an individual, your assets and liabilities are majorly into fixed income; of course, it depends on your compensation structure. If you are an employed person, you get the coupon, coupon and coupon and the final payment on retirement.

Therefore, at an early stage of your life, your major asset allocation is into fixed income. Hence, we are trying to include the human capital into the asset class, i.e. we are trying to say even if you incorporate all of your assets into other asset class, even then the asset allocation would be 90% into fixed income and 10% into equity. Thus, an asset allocation that includes human capital as an asset class is a more appropriate method of selecting assets.

As you age you like your Banker more!

If you consider financial assets, your balance sheet would have been so different- allocating 60-70% in equity and rest in other asset classes. How do human capital change, though? As you age, your allocation into fixed income increases and you tend to be on the safer side when the retirement approaches.

An asset class is a group of assets with similar attributes-on the basis of risk, return, characteristics or correlation with similar assets. Thus, individual asset class may not be classified into more than one asset class and hence should be mutually exclusive.

Approach Asset Allocation like a Pro

There are three approaches that are used to allocate assets in the portfolio:

  • Assets Only
  • Liability Relative
  • Goals Based

Assets Only: It is based on Mean Variance Optimisation. It focuses solely on the asset side of the balance sheet, and the liabilities are sort of ignored, i.e. Liabilities come as a part of the required rate of return perspective. For Instance, based on your goals, we set a required rate of return which is reflective of yourliabilities (PS: Liabilities we mean your/firms obligations, could be meeting tax payments, property instalment payment etc.). This means to meet your liabilities what you have to achieve, and then the assets are allocated to meet this return. Thus, the liabilities, in this case, are usually implicit. This approach is generally used by institutions who have non-contractual liabilities or by the individuals.

Liability Relative Approach: Under this approach, the liabilities are far more concrete. For instance, Banks, insurance companies or pension funds, more often use this approach. Liability Relative Approach chooses the asset allocation with the objective of funding liabilities when they become due. There are four types of Liabilities.

Goals Based Approach: The above-mentioned approaches may sound very fundamentally and technically correct, but a beginner might not be able to understand it. Hence, it becomes extremely challenging to serve the client better. So, in order to make it easy, a portfolio manager deviates from the optimised portfolio and adopt a method of service which is easier for the client to understand. This involves specifying asset allocations for sub-portfolios, each of which is aligned to specific goals ranging from supporting lifestyle and aspirational needs. Risk under this approach is limited to maximum probability acceptable of not achieving the specific goal.

Hang On! Let Us Throw in Some More Technical Terms

Factor Models in Asset Allocation and Strategic Asset Allocation: Using different asset classes tends to overlap the sensitivity of the portfolio to risk factors, for instance, changes in interest rate have an effect on every asset class-equity, bonds, Alternative Investments or any other asset class also.

Thus, factor portfolios which involve the long and simultaneous short position isolate the exposure of risk in that specific asset holding. Hence, Factor based models and investing are altering the way the financial planners and institutions construct portfolios and analyse risk. Strategic asset allocation is the starting point for portfolio construction where it is formed and is expected to be effective in achieving asset owner’s objective, given her risk tolerance and investment constraints.

To be or not to be - Active

Implementation Choices- Active v/s Passive: Factors influencing the choice of Active or passive include availability of investible and representative index, scalability of active strategies, beliefs regarding market efficiency etc. We can allocate the assets at the level of Strategic Asset allocation or on the level of the asset class.

  • Passive/Active Management of Asset Class Weights: Tactical asset allocation involves small deviations from strategic asset allocation to exploit opportunities. However, this approach introduces additional risk in return of additional rewards, e. positive alpha.
  • Passive/Active Management to Asset Classes: Passive management approach doesn’t respond to investors capital market expectations while active managers would attempt to generate additional returns relative to a passive benchmark.

Allocating to Illiquid Assets: Illiquid assets offer additional premium as compensation for illiquidity. However, determining assets is a difficult task due to lack of a proper index. Hence, risk budgeting comes to the rescue, which offers optimal risk allocation and offers maximum return per unit of risk.

Constraints to Asset Allocation

  • Asset Size: Size of the asset owner’s investment pool may be too small or too large and may capture the returns or risks efficiently. It is the most acute issue for individual investors than institutional asset owners. Small funds lack the expertise and have a lack of diversification, but these can invest in commingled funds to achieve diversification. On the other hand, large funds can offer economies of scale and has a greater power to negotiate management fees.
  • Liquidity: Under this constraint, two dimensions of liquidity must be considered-Liquidity needs of the asset owner and liquidity characteristics of the asset class. Portfolios with low liquidity and longer time horizons can benefit from illiquidity premium. To assess the appropriateness of asset classes, it is wise to access potential liquidity needs.
  • Time Horizon: As the time passes by, characteristics of both humans and asset change. Longer horizon allocations are more associated with higher risks. As humans age, her asset allocation is more inclined towards fixed income.
  • Tax Considerations: Taxes can materially impact the outcome of the portfolio and thus complicate the optimisation process. Thus, it is important for the taxable asset owner to consider the trade-offs between tax minimisation and returns.

Considering the aforementioned points, it becomes pertinent for the individual to consider a proper investment plan before pulling the purse strings. Like they say, “Plan your work and work your plan.”

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