Introduction to Strategic Asset Allocation
Introduction to Strategic Asset Allocation

Over the past few months we have been highlighting the various investment classes at the broadest level; domestic equities, international equities and fixed interest. There are, of course, a number of subsets of these and other separate classes such as listed property, infrastructure, commodities and alternatives, to name but a few. All of these investment classes have their own unique characteristics in terms of risk and return and offer different options for investors.

The proportion or weighting of these asset classes that an investor chooses within their investment portfolio is primarily driven by their risk profile; more specifically the level of risk they are willing to bear for the level of return. Typically, as with most things in investments and life, the higher the return on an investment, the commensurately higher the level of risk.

The starting point for Asset Allocation decisions is in determining what proportion of a portfolio should be allocated to Defensive Assets and what proportion should be allocated to Growth Assets.

  • Defensive Assets tend to carry lower levels of risk, are generally less volatile and are associated with lower returns over the long term. These assets include Cash, Fixed Interest and Bonds.
  • Growth Assets tend to have higher levels of risk, are generally more volatile particularly in the short term and are associated with higher returns. These assets include Domestic and International Shares, Listed Property, Infrastructure, Commodities and Alternatives.

Strategic Asset Allocation

This initial division of a specific proportion of portfolio into Defensive and Growth Assets is known as Strategic Asset Allocation.

Strategic Asset Allocation involve setting target allocations and then periodically rebalancing the portfolio back to those targets as investment returns skew the portfolio over time.

To determine your allocation to Defensive and Growth Assets an Investor needs to assess their Risk Profile. Once you have identified your Risk Profile a suggested Asset Allocation can be identified. This weighting of asset classes by risk profile is one of the most fundamental components and important considerations of the portfolio management process any investor will make.  

The freeing up of global investment options to every investor, such as international equities, corporate bonds, private equity funds etc, means every investor who is seeking to maximise their returns, while keeping their risk to acceptable levels, should be considering their investments in light of their strategic asset allocation. This process is most commonly referred to as wealth management.

Wealth management is essentially a tailored mix of investment management with financial planning principles to develop an investment strategy based on a thorough understanding of a client’s personal goals, situation and tolerance to risk. From this information, a portfolio of investments can be constructed which is diversified across, and within, asset classes and is designed to both protect the portfolio against short-term swings in any one asset class, while growing it over the longer term.

Strategic asset allocation is therefore an investment strategy which aims to balance risk and reward by apportioning a portfolio's assets according to an individual's goals, risk tolerance and investment horizon. The three main asset classes - equities, fixed interest and cash – all have different levels of risk and return, so each will behave differently over time. Asset allocation is one of the most important decisions that investors make; empirical research has shown that over time the selection of individual securities is secondary to the way that assets are allocated across equities, fixed interest securities and cash, which will be the principal determinants of investment returns.

Growth Assets versus

Defensive Assets

At its core, strategic asset allocation seeks to match the proportion of growth versus defensive assets with an investor’s risk profile, matching their return expectations and time horizon with their risk preferences. To this end, you will often hear academics and market professionals talk about the risk curve, also known as the efficient risk frontier, which is simply a theoretical plot of the various asset classes, against their respective observed risk (expressed as standard deviation) and return. As one would expect, moving along the risk axis by investing in higher risk assets provides an investor with a higher return, however the curve starts to flatten out as the investor continues to increase their exposure to riskier assets. Conversely, the more defensive the asset (the lower the risk), the more quickly the likely return falls.

Assets which are considered to be lower risk and hence lower return, provide a high level of capital protection and are collectively known as defensive assets; cash, term deposits, government & corporate bonds, floating rate notes and hybrid securities. The more conservative an investor, the more likely they will want to have a higher exposure to defensive assets and the more liquid their portfolios will be, given the shorter time horizon of their investment strategy, but at the expense of the return they will earn on those assets.

Growth assets tend to have higher returns than defensive assets over the longer term but come with more risk,or volatility, with the key asset class being equities and including both Australian and International equities. These assets will provide a more aggressive investor with the higher returns they seek, although they may need to have a longer time horizon, such that any short term negative swings, such as a market correction, provides the time for them to recover.

Risk Profile as a key driver in determining Strategic Asset Allocation

Patersons strategic asset allocation model recommends the following asset allocation relative to an investor’s risk profile as below.

Once an investor has identified which risk profile they fit into, then that risk profile would define their strategic asset allocation; so a growth investor would have 70% of their portfolio invested in growth assets and 30% invested in defensive assets. This strategy is a disciplined approach that involves assigning weights to different asset classes on the basis of an investor’s risk and return objectives and the capital market expectations. It is based on Modern Portfolio Theory, which assumes that every investor is rational and shows risk aversion (i.e. desire for high returns with the lowest possible risk).

The Defensive/Growth split is the broadest of the strategic decisions. After this, investors then need to set a target for the investments they will make within Defensive and Growth Assets, so the next step in this process is to determine which asset classes should be invested in, to achieve the targeted split of growth and defensive assets, resulting in a customised investment strategy.

Strategic Asset Allocation Model Refinement

Strategic Asset Allocation is a very prescriptive approach and might not be suitable for Investors who are assertive and are seeking good long term returns from Growth Assets but whom;

  • Have preferences for some Growth Assets such as Australian Shares over others such as International Shares; and
  • Have substantial holdings in some Growth Assets such as direct Property and Australian Shares and who do not want to substantially change their portfolio mix due to a number of reasons including tax (including CGT) considerations and transaction costs.

As part of the process of rolling out our risk profiling tools over the past few months we have been reviewing the data and refining the strategic asset allocation model, in order to optimise it in the best interests of our clients. As such, we have refined and simplified the earlier model, to address those specific aspects appropriate for Australian investors, for example those investors in pension phase within a self-managed superannuation fund.

Our refinements to the model recognise that most Australian investors have a preference for investing in Australian equities, given the confidence that comes from knowing these companies over many years and utilising their services on a day to day basis. This, plus the strong dividend generation and associated franking credits focused on by Australian companies and their management have meant that Australian equities have performed in line with global peers, once dividends and tax have been taken into account.

However, that is not to say we don’t still believe international equities shouldn’t have a meaningful position in investors’ portfolios; they certainly should and for the young, as well as the young at heart, global companies such as Apple, FaceBook and Google are as ubiquitous as Coles, Caltex and Telstra. For a large and increasing number of investors that know these companies because they use their services daily, means international equities are not quite so ‘foreign’ as they used to. Indeed, now being able to invest in these companies directly or taking an exposure to international markets via index exchange traded funds (ETFs) provides a whole new level of opportunity for investors, compared to what was available some 10 to 15 years ago.

Adding international equities to your investment portfolio or strategy takes advantage of the most significant benefit of asset allocation in providing diversification while helping to manage the risk (volatility) of a portfolio.

Patersons Strategic Asset Allocation Model

Our strategic asset allocation model for the various asset classes by risk profile is presented below:201212_AssetAllocation_Chart5-2.jpg
An example of this for a Growth Investor would be as follows:

We view Australian Equities as a key component of any Australian investment portfolio for the reasons highlighted above. Of course, the risk/return profile from Australian shares can vary at the individual share level and we covered some of that in September’s piece on Portfolio Construction. Most importantly, we would recommend a high weighting be given to larger, quality companies who are able to grow their earnings through the economic cycle with high return on equity, strong free cash flow and low levels of gearing. Interestingly, a number of these quality growth companies can be described as such because they have some portion of their business in other parts of the world, however they would still be considered Australian Equities within the portfolio.

International Equity exposure can be achieved in a number of ways, either directly purchasing shares in FaceBook, for example, or indirectly via a US index ETF. Alternatively, investors can achieve international exposure by investing in an unlisted international equity managed fund, a listed investment company which invests in international equities or a listed international equity managed fund ETF. However, investing directly in international equities is again not as simple as it seems; like investing in Australian equities, an investor needs to determine which specific shares they are going to invest in. What complicates the issue, is first deciding which region and/or market to invest in.

We view Listed Property & Infrastructure as having very similar risk and return characteristics to each other in having stable long term cash flows. As a result, this asset class has a lower risk/return expectations than equities, which makes it more suitable as a growth asset for conservative and moderate investors. Investors with higher risk profiles should have relatively less of this asset class within their portfolios, as part of their growth asset allocation.

Within Fixed Interest we find very few reasons for Australian investors to be holding international fixed income securities; and while this may change in the future, we see no sensible reason to ‘force’ an exposure to this asset class in the current environment. As such, our model asset allocation is wholly exposed to Australian fixed interest securities. However, while each asset class within Fixed Interest provides some form of income and capital protection there are variations; for example, hybrid securities contain fixed interest-like characteristics with equity-like characteristics.

As a result, our asset allocation model takes into account these risk/return characteristics within each investor risk profile. Given the likelihood of higher interest rates in the short to medium term, we currently prefer to have an exposure to floating rate securities or to shorter duration term deposits or fixed rate bonds.

Cash is self-explanatory and the only comment we would make is that investors with more than $250,000 in cash should spread their deposits over more than one institution (in order to take advantage of the Federal Government deposit guarantee).

Investing directly in international equities is again not as simple as it seems. An investor needs to determine which specific shares they are going to invest in.

Tactical Asset Allocation

Over the long term, strategic asset allocation is quite rigid, while using a tactical asset allocation approach allows investors to determine a range of percentages that they are prepared to invest in certain assets within their investment portfolio.

Our Patersons strategic asset allocation model has a recommended benchmark asset allocation from which we then apply a valuation and tactical positioning overlay to determine the appropriate weighting in each asset class; this is tactical asset allocation and is one of the key refinements we have made to our model. The advantage of this approach is that allows for much greater variations in portfolios between investors to suit their particular objectives, situation and needs.

For the same Growth Investor, an example of this might be as follows;


This approach also enables investors to add a market timing aspect to their portfolio and also enables investors to take advantage of economic conditions that are more favourable for one type of investment rather than another, taking into account such factors as global economic growth, monetary & fiscal policy, the direction of interest rates and relative equity market valuations.

The other benefit of this approach is that it allows longer term investors the ability to adopt a buy and hold approach, without being required to balance regularly and creating a potential capital gains tax liability.

Regular Review

While the broad allocation to growth versus defensive assets does not change a great deal over time, unless an individual’s personal and/or financial circumstances change, the asset allocation decision is not set-and-forget; it needs to be reviewed regularly and adjusted when required as asset classes grow at differing rates.

In conclusion, asset allocation is the most important part of the portfolio construction process; it can be strictly passive in nature or can be a very active process. The asset mix decision heavily depends on an individual’s age, risk tolerance, goals, time horizon and return expectations and as such it is important to note that an asset mix for one person may be completely inappropriate for another.