4. Asset Class Suitability

The Construction of a Portfolio Begins With Asset Class Allocation. In almost all cases, investors acquire assets based on the investor’s perception of how each asset will perform in the future. Little, if any, time was spent determining which asset classes might be most appropriate for the investor, and virtually no attention has been paid to the risk characteristics of the individual investments; how each investment will perform relative to each other investment, or how a portfolio containing all of the investor’s assets might perform.

It is imperative that the advisor choose those assets classes that, when combined, will meet the investor’s growth and risk requirements. For example, investors that are more risk conscious should not have equities and long-term bonds in their portfolio since they tend to have a positive correlation to each other, thereby compounding the volatility of the portfolio.

The importance of allocating capital based on risk/return characteristics and the relationship of each possible investment to every other possible investment in a portfolio was clearly demonstrated in a seminal study of 91 large pension plans. The study sought to attribute the variation of total returns among the plans to three factors:

  • Asset allocation policy
  • Market timing
  • Security selection

The chart above dramatically demonstrates the study’s conclusion that asset allocation is the primary determinant of investment performance.

The process of asset allocation may include one or all of the following approaches:

Strategic Asset Allocation

– uses historical data (mean rates of return, standard deviations and covariances) in an attempt to understand how the asset has performed and is likely to perform over long periods of time. The goal is not to “beat” the market, but to establish a long-term investment strategy using a core mix of assets.

Tactical Asset Allocation

– uses periodic assumptions regarding the performance and characteristics of the assets and/or the economy. This approach attempts to improve portfolio performance by making “mid-course” changes in the long-term strategy based on near-term expectations.

Dynamic Asset Allocation

– involves changes in investor circumstances, which may lead to the modification of policies, objectives and/or risk tolerances. Resulting changes are intended to maintain equilibrium between the investor’s policies and objectives and the asset allocation process.

To some degree every investment program involves Tactical and/or Dynamic asset allocation. The example I often use is taking a sailboat from San Francisco to Hawaii. If I set a course to get there in a straight line, I will never see the islands. Changes in the winds, currents and weather will all affect the heading of the boat. Consequently, we must always review our strategies and make whatever modifications (Tactical Allocation) are necessary to maintain the course to our objectives.

How can you determine appropriate investments?

Prior to designing the investor’s new portfolio, the advisor and the client should consider all assets that are acceptable to the investor. Based on the client’s risk tolerance and economic situation, the advisor should recommend those assets that, based on historical or forecasted performance, will provide the highest possible rate of return without exceeding the client’s tolerance for potential loss. Selected assets should have negative or very low correlations to each other and, ideally, high covariances (covariance measures the timing, direction and momentum of the movement of two independent variables). The advisor should

never

:
  1. recommend assets that all have a positive correlation to each other
  2. recommend assets that provide greater volatility than the client is willing to accept
  3. recommend a superfluous asset. If two assets are positively correlated, and one has a lower historical or estimated rate of return and a higher standard deviation (volatility), the latter investment should be excluded from consideration.

Having said this, there may be times when you, as the advisor, have certain knowledge or expectations that warrant the inclusion or exclusion of some assets. The classic example would be Japanese or Pacific Rim securities in 1988 when most advisors were under-weighting Pacific Rim securities in portfolios as they were considered substantially over-valued.

How much diversification will be required?

It is important to note that diversification is not a function of how many assets or securities are included, but rather are they negatively correlated and do the selected assets balance the portfolio. For example, if you had an equity portfolio of 100 stocks, the portfolio is no more diversified and the systematic risk of the portfolio is not reduced any more than if you had only 20 stocks across industry lines. In other words, adding 80 more stocks to the portfolio did not reduce the risk of the portfolio. In fact, having just two perfectly negatively correlated assets in the portfolio would represent a portfolio which will exhibit zero risk and a constant and predictable rate of return (it should be noted that we have never seen two perfectly negatively correlated assets). The point is, portfolios that contain only three or four assets may, in fact, be far more diversified than portfolios that contain 9 or 10 assets.

In some cases you may find that although you have included several assets, an Optimization algorithm may only recommends three assets. Mathematically the relationships of the assets (returns, correlations and covariances) will support the recommendation. However, you may feel that additional “diversification” is necessary. Remember, your knowledge, experience and understanding of your client’s needs are as important as any mathematical algorithm in the asset allocation programs. It is also true that tools such as SCANalytics and the algorithms employed are not magical and therefore should only be relied upon as “mathematically” probable. There is not any means by which these tools can know about current or possible economic events which might further influence the performance of any asset or assets without your introduction. Your experience, expertise and knowledge will be useful in guiding the composition of the portfolio.

It might be useful to establish a list of 15-20 generally recommended asset classes to start and add others as may be required for each individual investor. For example:

It is always recommended that, prior to selecting specific investment vehicles, advisors consider the asset classes to be considered and their relationship to all other asset classes in the portfolio. Without a diligent analysis of the client’s needs and risk and the use of sophisticated asset allocation tools, it will be almost impossible to meet FINRA and ERISA regulations.

Ticker symbols and indexes are among over 5000 used in AdvisoryWorld’s SCANalytics

5. Designing the Proposed Portfolio

The process for developing portfolios that will achieve client goals without exceeding their risk profile is:

  1. Determine which Asset Types are appropriate (i.e. Cash Equivalents, Domestic Equities, International Bonds, Real Estate)
  2. Determine which Asset Classes are appropriate (i.e. Large Cap Growth, Small Cap Value, Domestic Bonds, Emerging Markets, Hedge Funds, REITs)
  3. Determine the estimated rate of return and volatility assumptions
  4. Determine what, if any constraints are placed on Asset Types (i.e. maximum of 40% Equities, 25% International Bonds)
  5. Determine what, if any, constraints are placed on Asset Classes (i.e. 20% Large Cap Growth, 10% REITs, 5% Gold)
  6. Find securities that are correlated to each Asset Class

There are several ways to develop portfolio proposals,

First « 1 2 3 4 5 6 » Next