Top down asset allocation in 2013 #2

In Part 1 of his CPD paper on asset allocation modeling, Ray Griffin detailed a step-by-step process to deploying a top down approach to designing balanced client portfolios.

In Part 2, he now goes deeper into asset allocation and portfolio risk management but first he outlines stress testing as a means of understanding the impact on client portfolios if certain events were to occur.

It’s all well and good to methodically work through a top down asset allocation process but how can you, as the person recommending investments for clients, begin to understand how a portfolio might behave in the future?

This is not to suggest that the future can be known but, rather, to recommend that you carry out some scenario planning; some ‘What if?’ scenarios otherwise known as stress testing of portfolio models.

Stress testing
At every minute, of every day, investment portfolios are being ‘stressed’ through the forces at play in world economies and the reflection of those forces in markets.  Reward requires risk and demand is theoretically met by supply (and vice versa) all of which dictates that nothing is certain in asset allocation.

Stress testing of portfolio models can be readily achieved through relatively straightforward computer spread-sheeting.  In effect, stress testing is simply a ‘What if?’ examination of certain potential scenarios.  It attempts to understand the impact on portfolios of certain events such as large interest rate movements, share market declines, dividend reductions, inflation and so on.

• What if share markets declined by 20%?  What if they declined by 50% or numerous other declinations?
• What impact on portfolio income would a 300 basis points decline in interest rates have on overall portfolio income?
• What impact would deterioration in dividend payments have on overall income for clients?

The outcomes modeled from considering such scenarios and other stress tests will provide you with a much deeper insight into potential portfolio behavior. While the real world is always different to spreadsheet outcomes, stress testing nevertheless is a vital component of portfolio modeling.

Right now, do you have any insight into how your recommended portfolios might behave under future scenarios?  To what extent, approximately, might your clients’ portfolios decline under the above example scenarios? What will the impact be on portfolio income under interest rate decline scenarios?

And for all of these questions, what options do you have to ameliorate such impacts? What, if anything, might you change in your asset allocations?

So, a quick recap. To this point in this two-part CPD paper we have:

• Followed an analytical process to determine domestic versus international weightings in portfolios
• Moved to determine weightings domestic investment sectors
• Developed a framework through which to understand how portfolios might behave under future scenarios – stress testing of portfolios.

We’ll now move to look more closely at the selection of individual investments to build portfolios in line with the overall asset allocation models you develop.

1. Fund manager style and diversification
The very essence of diversification is that allocation across markets should not be consigned to a single funds management company.  Funds managers are rarely (if ever) investing successfully across all sectors be that domestically or internationally, so to entrust your clients’ entire portfolios to a worldview taken by a single company is a very big call.

As such, diversifying across funds manager ‘styles’ is a further step in managing portfolio risk.  For example, if a fund manager were a so-called ‘value’ investor, the complementary co-allocation would be to a bottom-up style fund manager(s). To pin your hopes on a single management style, e.g. value, might also be a big call regardless of how many such value managers the equities allocation is spread across.

2. The last step – investment selection
The final step in a ‘top down’ approach to asset allocation is the selection of individual investments. While this is an important step, it’s arguable that getting the broad sector allocation right will have a much greater impact on overall portfolio performance.

A portfolio can cope (subject to weightings) with an investment that underperforms its peers however a mis-allocation to sectors, such as being over/underweight sectors, can result in quite deleterious outcomes overall for portfolios, particular portfolios which are overly dependent upon the performance of a single sector.

In terms of managed funds, both qualitative and quantitative aspects must be considered in developing an Approved Products List.  Similarly, with direct assets such as listed securities, performance track records (quantitative) and company management, strategy, competitiveness, board performance and overall business direction (qualitative) influence decisions for APLs.

3. Research
The top down approach is finally finessed through use of either internal and/or external research that should aid in ‘filtering’ the number of investments that will appear on the Approved Products List for each licensee and its representatives.

Another risk management consideration
While not strictly an asset (sector) allocation issue, in managing the overall financial risk for clients, one step that is sometimes overlooked is the need to be mindful of legislative risk. In Australia, the constant risk that looms large is the prospect of changes to superannuation legislation.

Witness the recent rumors of changes to the tax-free status of pensions from superannuation accounts of $1 million or greater.

In addition to taxation risk within superannuation i.e. the risk that it loses some or all of its taxation advantages, there is also the possibility that, if the political will should ever prevail, access to lump sums of capital from superannuation could be withdrawn. Such a change would be made in order to enhance the potential for superannuation benefits to ‘go the distance’ through someone’s lifetime.

Having a portion of capital invested outside superannuation would assist in managing the risk which might emerge from future changes to the legislation.

Summary
The ‘top down’ asset allocation is founded on a deep understanding of the status and potential trend direction of international and domestic economies and markets.  The methodology is based on the following process:

1. Understanding the current world economic and investment market conditions
2. Developing initial, broad, allocations to domestic and international assets mindful of current conditions and in accordance with investors risk tolerance profiles
3. Determining overall allocations to each sector, again, mindful of investors risk profiles
4. Identifying individual assets/investments within those sectors.

While asset allocation is in itself a risk management process, in Australia, it needs to be complemented with managing the risk of changing investment legislation especially in regard to superannuation.

 

Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes.