Asset allocation is one of the most important decisions that investors face. But asset allocation – deciding what mix of different investments to hold – seldom gets the attention it deserves. Instead, investors typically spend most of their time trying to pick winning stocks or seeking to “buy at the bottom and sell at the top.”
As a result, they can too easily end up with a portfolio that runs too many risks while making too little a return.
To find out how and why asset allocation works, Arabian Knight approached Dr Gregory Van Inwegen, Global Head of Quantitative Research and Asset Allocation at Citi Investment Management, Citi Private Bank’s discretionary portfolio management organisation.
Prior to working for Citi, Dr Van Inwegen was the Chief Investment Risk Officer at Ivy Asset Management, Director of Research at Rydex Investments and a Director at Deutsche Asset Management.
POWER OF DIVERSIFICATION
“Asset allocation basically involves spreading your investment funds across different asset classes, like stocks, bonds, cash and other investments,” says Dr Van Inwegen. “This is called diversification. With proper diversification, you can lower the overall risks you run without sacrificing returns. It works because different asset classes tend to behave differently over time. For example, when stocks are going down, gold may be going up.”
“To diversify properly, it is important to have access to a broad range of asset classes,” he continues. “As well as the different varieties of stocks and bonds, this can include commodities, hedge funds, private equity and real estate. It is also important to diversify across different countries and regions, such as holding stocks from both developed and emerging markets.”
Having decided which different asset classes to diversify across, the next decision is how much to put into each one. “Getting a suitable mix involves more than arbitrarily splitting fifty-fifty between stocks and bonds,” says Dr Van Inwegen. “Asset allocation requires the investor to make long-term estimates of what each asset class will return, the amount of risk involved in each, and how much they may move together.”
A SUITABLE MIX
With these estimates, it is then possible to calculate what mix of investments to hold in order to try and reach the investor’s own personal objectives. These include the return an investor wishes to make and the amount of risk he is willing to run in order to do so. But there are also other factors that may influence what mix is chosen, he points out.
For example, an investor may only want to hold liquid investments – those that can be readily bought and sold. Or, there may be assets, countries or industries that an investor does not want to invest in for religious or other personal reasons.
“The appropriate mix of different asset classes, given an investor’s goals, is called a strategic asset allocation,” says Dr Van Inwegen. “The investor uses this to build an actual portfolio of investments. But the work isn’t finished when the portfolio has been built. The next task is to monitor its performance and also review the strategic asset allocation regularly. As the outlook for long-term returns and risk changes, the strategic allocation should shift too.”
“Over time, some asset classes will perform better and some will do worse,” he continues. “As a result, the make-up of the portfolio will stray away from the strategic allocation. This requires a rebalancing of the portfolio to get it back in line with the allocation. To do so, the investor sells some of the asset classes that have gone up, and buys more of those that have gone down.”
A DIFFERENTIATED APPROACH
While traditional asset allocation has proven very worthwhile over the long run, it has faced big challenges in the period since the turn of the millennium, says Dr Van Inwegen. “A lot of traditional approaches failed to anticipate the poor returns on stocks in the decade from 1999, or that bonds would beat stocks,” he says. “In response, we at Citi Private Bank have developed our own strategic asset allocation methodology called ‘Adaptive Valuation Strategies’ or ‘AVS’.”
“AVS takes a different approach to many traditional asset allocation methodologies, particularly when it comes to returns and risk,” he continues. “It recognises that current asset-class valuations affect future returns. Low valuations are often followed by high returns and high valuations by low returns. AVS takes this into account when estimating future returns. It will likely then allocate more to asset classes with higher estimated returns and less to those with lower ones.
“Because AVS uses valuations in this way, its estimates of returns can often look very different to those of other methodologies. During the late 1990s, it would have recognised that stocks were richly valued and would have correctly estimated their poor returns over the next decade. Based on this, it would have suggested lowering allocations to stocks. By contrast, many other approaches merely assumed that returns would continue to be high or at least close to their long-run averages, and allocated too much to stocks ahead of a very difficult period,” he says.
So, what are AVS’s current estimates of future asset-class returns?
Over the next ten years, it estimates that Global Developed Market Equities will return an annualised 6.3 per cent and 9.3 per cent for Global Emerging Market Equities. This compares to 2.1 per cent for Global Developed Investment Grade Fixed Income and 1.7 per cent for cash.
As well as the way it estimates future returns, AVS also handles risk rather differently to traditional asset allocation. “We believe the most important risk for an investor is that of a portfolio suffering severe losses during a crisis,” explains Dr Van Inwegen. “Severe losses have happened much more often in real life than traditional risk-measures based on volatility would suggest. To estimate the sort of losses that could occur, AVS looks back over almost 90 years of financial-market history.”
“The allocations that AVS suggests are also highly customised to clients’ individual needs,” he continues. “For example, it produces allocations for those that don’t want to hold illiquid investments like private equity or real estate. And it can accommodate clients who want to skew their holdings towards their own home-country or region. It also takes their currency preferences into account.”
“AVS’s allocations provide the foundations upon which client portfolios are built. Citi Investment Management – our discretionary investment management organisation – implements these allocations in its portfolios. And they are also the starting-point when we advise clients on customised portfolios,” says Dr Van Inwegen. “Having a disciplined approach like this is key for any investor who seeks to enhance returns and control risks.”
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