Stock picking or asset allocation?
Investment press and marketing often seems to suggest that investing is all about stock picking.
However, evidence shows that investment results depend mostly on the assets chosen, with academic studies suggesting around 90 per cent of a portfolio’s return variability can be the result of what's called strategic asset allocation, or SAA.
Given this, we believe the emphasis for clients should be on having an SAA that's aligned to their objectives, and built from a robust, repeatable investment process.
Setting strategic asset allocation
SAA is defined as the strategic split between different types of assets.
At its highest level, it’s the central allocation to equities, property and bonds. But there are additional levels, such as the regional split of equities or the split between bonds.
The SAA is the key determining factor of a portfolio’s expected level of future return, and the level of risk being taken.
Three key inputs to setting an SAA include:
In other words, what is the client trying to achieve and by when?
Knowing this gives a sense of the level of return required by the portfolio, and what level of exposure is required to assets that have higher expected returns, albeit with greater risk.
The typical starting point for model portfolios is based on risk buckets.
Yet an alternative approach is emerging which is to start with the goals the clients are trying to achieve.
2) Opportunity set
Clearly, there is a broad range of asset classes available for investment.
These need to considered in terms of their appropriateness and the role they may play.
Factors to bear in mind here include the evidence of future sources of return and the asset class’s liquidity - are these aligned to clients’ needs? Only assets that pass this assessment should be included.
Other key tests might be the range of assets needed to meet a wide range of goals; simplicity over complexity; and risk and return drivers that are evidence-based and have a sound economic rationale.
The next stage is combining the identified asset classes to design an SAA that's aligned to client objectives, but also spreads the risk.
Data analysis supports this process by projecting how different SAAs may perform in different economic scenarios.
It's also worth considering how the SAA you arrive at relates to your firm's investment policies and beliefs. Are the two aligned with each other?
Finally, SAAs should be set with a time horizon that's aligned to clients’ objectives, with asset allocation reviewed and rebalanced on a regular basis.
Ultimately, having the appropriate SAA in place is likely to be the key driver of a client’s ability to achieve their objectives, and an investment strategy that matches with their individual goals.