CPD: Asset allocation – the driver of portfolio returns


This allocation of money into investible assets in portfolio construction has evolved over time to become an integral part of investment.

Modern Portfolio Theory, pioneered by Harry Markowitz in 1952, introduced investors to the risk/return trade-off. It focused on how investors can construct a portfolio to maximise expected return for a given level of risk. This allocation of money into investible assets has evolved over time to become an integral part of investing.

This article will explore asset allocation – strategic, tactical and dynamic – and consider how each can add value to an investment portfolio.

What is asset allocation?

When Markowitz first introduced the concept of asset allocation, there were but few asset classes to choose from – shares, bonds, property and cash. Today there are significantly more. Share investments can span developed and emerging markets, large, mid and small-cap companies, or be focused on specific sectors. Bonds have evolved into fixed income, which can be short or long-dated, issued by governments, semi-government authorities or corporates in developed or developing countries. Hybrid investments carrying attributes of shared and bonds proliferate, while esoteric ways of packaging debt for investors abound. Then, of course, there is the burgeoning alternatives sector.

Asset allocation aims to balance risk and return by allocating a portfolio’s assets according to stated objectives, which include return goals, risk tolerance and investment horizon. Assets are divided within and across asset classes and aims to provide diversification, an investment tenet that underpins portfolio construction.

For investors to benefit from diversification, investments need to be allocated across assets that are not correlated with one another; or, in other words, behave differently from each other. Every asset class has a relationship with others – some have very little or no relation to each other (or low correlation), whereas others are inversely connected, performing at different times of the investment cycle (negatively correlated). Other assets might be highly correlated, meaning they tend to do well – or not – at the same point of the investment cycle.

Diversification is a key investment tenet because it helps to spread risk by allocated assets across a range of investments, thereby reducing the potential for losses. Diversification not only spreads investment risk, it can help increase longer-term returns by minimising drawdowns over an investment cycle.

Asset allocation is often held up as the driver of overall returns, more so than individual investment selection. As such, asset allocation needs to be viewed as a dynamic process, constantly reviewed to ensure the asset mix will continue to meet investors’ objectives.

Strategic asset allocation

Strategic asset allocation aims to balance a portfolio’s risk and return by setting the target weightings of different asset classes according to a given set of investment objectives, time horizon and risk tolerance. The output is a proportional combination of assets based on the expected risk and return for each asset class. It is not set and forget; asset allocation needs to be rebalanced within target ranges from time to time, as investment returns can impact allocation to asset classes within the portfolio over time.

Asset allocation models are designed to meet specific investment objectives; this generally informs the proportion of growth and defensive assets, which is a key role of strategic asset allocation.

A more conservative investment objective (lower growth, more risk averse, capital protection) generally favours a greater proportion of defensive assets. A high growth objective typically favours growth investments.

Figure one provides strategic asset allocation ranges for three diversified funds offered by an Australian superannuation fund – conservative, balanced and high growth. The allocation ranges are driven by the investment objectives for each portfolio.



Strategic asset allocation is generally driven by a number of assumptions, such as long-term historical risk, returns and correlation of asset classes, or may be based on forecasts of long term returns, risk and correlation of asset classes. Forecasts used in strategic asset allocation are generally based on long term expectations for economic growth and inflation, interest rates, corporate earnings growth and other economic and market factors.

Tactical asset allocation

Tactical asset allocation takes a more active stance on the relatively passive strategic asset allocation, by adjusting target asset allocation weights for shorter periods. This aims to opportunistically allocate capital to the most attractive asset classes at different times in the investment cycle.

The key difference between strategic asset allocation and tactical asset allocation is the time horizon across which asset allocation decisions are made. Strategic asset allocation models are focused on investment across the investment cycles to generate long-term average returns from each asset class; tactical decisions aim to generate attractive returns and avoid losses by focusing on a shorter term outlook for asset classes and investments within those asset classes.

Tactical asset allocation decisions can be based on a range of factors; relative valuations between asset classes, momentum or investor sentiment. Decisions can be made at the fund manager’s discretion or may be systematic or model driven.

Dynamic asset allocation

While tactical asset allocation considered to be short-term and strategic asset allocation longer term, dynamic asset allocation is somewhere in between. Like tactical, dynamic asset allocation is a derivation from strategic asset allocation. The difference, however, is that tactical asset allocation is generally adopted in conjunction with strategic asset allocation. Dynamic asset allocation may be used as a discrete approach to allocating assets.

Dynamic asset allocation is a recognition that asset classes often behave in different ways at different points in economic and market cycles. As a result, it requires the investment team to constantly adjust the mix of assets as markets rise and fall, and as the economy strengthens and weakens. The dynamic asset allocation process allows a portfolio to reflect new information and adjust the asset allocation accordingly.

At its simplest, a dynamic asset allocation strategy sees the sale of assets that decline and the purchase of assets that increase in value. For example, if the Australian sharemarket shows weakness, a dynamic asset allocator would sell Australian shares in anticipation of further decreases; conversely, if the market is strong, they would purchase shares in anticipation of continued gains.

As such, dynamic asset allocation relies on a portfolio manager’s expertise and judgment, rather than a target mix of assets. It generally involves regular portfolio adjustments over the shorter term in response to market or economic conditions. Dynamic asset allocation typically has no target asset mix, because asset allocation decisions are driven by assessments of current and future market and economic trends.

Dynamic asset allocation generally does not rely on historical correlations. Correlations can change over time and can increase during economic instability. For example, prior to the Global Financial Crisis, it was widely accepted that bonds and equities are negatively correlated. During the GFC – and several times since – that correlation changed significantly.

Dynamic asset allocation recognises that markets are driven by cycles, both longer term cycles and ‘mini-cycles’. A multi-year ‘secular’ cycle generally drives the primary trends in the share market and are driven by valuations. Shorter cycles, often driven by investor sentiment, economic conditions and central bank actions, can also impact investor returns. As outlined in the following case study, ‘mini-cycles’ can have a significant impact on the risk and return profile of a portfolio.

Case study: Insight Investment – Government bonds in a low inflation world – an asset allocation perspective

Globalisation and technology have been key factors in the low inflation story. There has been some academic debate as to whether the dis-inflationary impact of globalisation may be waning and, amid President Trump’s administration’s use of tariffs as a trade weapon, that may well be the case. But some analysis suggests the impact of technology on inflation has been increasing. At present, technology may well be exerting a greater role than globalisation on low inflation in the US.

So long as the inflation backdrop remains benign, it is likely that the equity-bond correlation will remain negative. As a general rule, the role of government bonds in Insight Investments’ multi-asset portfolio is determined by two key factors:

  • The fundamental assessment of their attractiveness on a standalone basis
  • Their potential to act as a diversifying asset

At current levels of yield, it would be controversial to make a strong case to hold government bonds on an absolute valuation basis. But on the latter criteria, the case is clear.

In a low inflation regime where CPI consistently undershoots central bank targets, government bonds are a diversifying asset in an environment where risk assets are highly dependent on the growth outlook.

Many of Insight Investments’ asset allocation models tend to focus on relative valuations. Specifically, income (dividends for equity, coupon from bonds) are the most stable component of the return structure in each asset class over the long-term. However, these series trend through time (i.e. they are not stationary). That is probably because of changes in inflation and risk premia which cause ‘regime shifts’. De-trending the relative valuation series gets around many of the problems of ‘changing levels’. These ‘rate of change’ models, based on the dividend-yield gap, tend to perform better than their unadjusted counterparts.

Such indicators are useful because even in an environment where the correlation between equities and bonds is generally negative, we have seen windows where that correlation switches and sharp rises in bond yields adverse impacts on equity markets and other risk assets can have – as they did, for example, in the ‘tapertantrum’ of 2013.

Clearly, at present, yields would have to back up some way to present a valuation threat to equity markets. But could it be that the benign inflation environment that has enabled government bonds to perform so well will eventually impact on equities which, in turn, could drag the economy lower?

Source: Global Macro Research – Asset Allocation and Growth Cycles August 2019

There is a significant body of research that confirms the importance of asset allocation in determining portfolio returns from a diversified portfolio. Advisers should consider the type of asset allocation used to build portfolios for clients, whether investing in a multi-asset or diversified fund, or through a managed account. Asset allocation decisions, particularly when market conditions change, can determine whether clients’ investment objectives are met.


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