Asset allocation is a very important aspect while creating and managing a portfolio. It has a direct impact on overall returns. If more money is allocated to riskier assets such as emerging market debt, small-cap stocks, cryptocurrencies, etc the return distribution of the portfolio exhibits a more prominent negative skew. In simple terms, negative skewness indicates that the portfolio will likely experience frequent small gains but infrequent large losses.
It is a well-known fact that equities outperform in a buoyant economic environment but what happens to such a portfolio when the cycle reverses, i.e., the economy goes into a recession?
This portfolio is likely to severely underperform the market as these asset classes are worst hit in a recession. It is a well-known fact that government bonds & gold perform well during periods of economic downturn. Hence, distributing funds among different asset classes such as shares, bonds, commodities, real estate, gold will help to minimize the skew and protect the investor against large losses in adverse periods.
Let us take the example of Norway’s Sovereign Wealth Fund, which is the world’s largest sovereign wealth fund with a total fund of USD 1.1 trillion. It is managed by Norges Bank of Norway. As of May 2021, the fund has invested in 9123 companies across 73 countries and 4 investment areas.
Asset allocation should take into account an investor’s risk tolerance, expected return, and time horizon.
Various methods of asset allocation:
Broadly, there are six methods of portfolio asset allocation:
1. Strategic Asset Allocation
This is the basic portfolio asset allocation method where capital is allocated proportionally into various assets based on their risk and expected return. It also takes into account the time frame. The portfolio manager can set a target and rebalance the portfolio from time to time. The portfolio manager also diversifies the portfolio and generally practices the buy and hold method to achieve the desired return.
2. Constant-Weighting Asset Allocation
This kind of asset allocation method takes into account the weights of individual assets in the portfolio. The portfolio is rebalanced based on the weights. For example, when one asset declines in value, it is purchased more to maintain its overall weight in the portfolio. There are no rules concerning timing or balancing the portfolio. However, the portfolio is reviewed from time to time to achieve the desired outcome.
3. Tactical Asset Allocation
Although portfolio managers may keep a long-term view, they may have to make tactical changes in the portfolio from time to time to take into account unusual or exceptional circumstances. This helps the portfolio managers to take advantage of sudden opportunities in the market.
This can be considered as a moderately active strategy where short-term profits can be obtained. However, this method requires significant expertise and knowledge of the market.
4. Dynamic Asset Allocation
This is also an active asset allocation strategy. In this method, the portfolio manager constantly monitors the rise and fall of the market and adjusts the portfolio accordingly. This method is heavily dependent on the portfolio manager’s judgement.
5. Insured Asset Allocation
In this asset allocation strategy, the portfolio manager establishes a base portfolio value below which the portfolio is not allowed to drop. The primary aim is to achieve a return above that base value. This method involves active portfolio management, research, forecasts, judgement, and the portfolio manager’s expertise.
So, what happens if the portfolio value drops below the base value?
The portfolio manager buys risk-free assets such as Treasury bills to bring the value up to the base value.
This kind of asset allocation methodology is suitable for risk-averse investors who don’t want their portfolio to go below a certain amount. As a result, the portfolio manager avoids risky investments, to avoid dips in the portfolio. It is important to keep in mind that by avoiding risky investments, the investor may also be foregoing potential returns that come with them.
6. Integrated Asset Allocation
This kind of asset allocation takes into account both risk in the asset mix and economic expectations. The signature aspect of this method is taking into account investor’s risk tolerance. This strategy is a combination of all the above methods and risk tolerance. Hence, it is a broader asset allocation method.