Thursday Trivia ~ Asset Allocation (Series 2 of 3)

Thursday Trivia ~ Asset Allocation (Series 1 of 3)
June 9, 2017
Thursday Trivia ~ Asset Allocation (Series 3 of 3)
June 29, 2017

Previously in Thursday Trivia, we discussed about what Asset Allocation is and touched upon Strategic Asset Allocation. In a nutshell, it’s important to look at what an individual’s money is doing at an overall level rather than merely checking the stock prices everyday and wondering whether enough money could ever be saved. Many a times, in our profession as Wealth Managers, we meet investors whose only concern in equity market. When asked for other investment avenues, a standard reply is fixed deposit which most of them are not worried about unless the interest rates go low, in that case there is a strong urge to jump in the equity market. Not to discredit an important fact, that technology has eased entry points into the capital markets.

In this Trivia, we will look at Tactical Asset Allocation and Dynamic Asset Allocation.

Tactical Asset Allocation

As the name suggests, it is an active portfolio management strategy that shifts the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors. This strategy allows for taking advantage of certain situations in the market place to create some additional value. It can be termed as moderately active strategy than Strategic Asset Allocation. However, there is always reversion to original asset allocation mix once the short to medium term value is added to the portfolio.

5 brief characteristics of Tactical Asset Allocation are:

  1. It is a view based strategy in which asset allocation is based on views of relative asset class performance.
  2. It involves tactically increasing a portfolio’s exposure to those assets that are relatively attractive and reducing a portfolio’s exposure to overvalued assets.
  3. Short-term adjustments in asset allocation are frequently made so that the portfolio can earn higher returns and beat the performance of benchmark indices.
  4. Timing and active management of risk are key components of tactical allocation. Entry into asset classes and exits from investments have to be timed correctly.
  5. Factors that impact asset class performance are continuously monitored and assessed to take the correct calls.

Let’s simplify the concept using an example:

Aman and his wealth manager decided to carry out Tactical Asset Allocation. Since, Aman was keen on taking advantages on strong sectors in different asset classes. Once the advantage was taken care of, they would return to their original asset allocation mix. With Investment Capital of Rs. 1 crore, they mutually decided to keep 40% of their money in equity market, 30% in fixed income securities, 20% in commodities – gold and balance 10% was kept as cash.

After a year, on a periodic review, Aman’s wealth manager suggested to increase the allocation towards gold as data suggested a very good opportunity for the next 2 years. More than Aman, his wife was thrilled with the idea. Gold is always special, whether it’s physical or kept in a demat format through Exchange Traded Funds. However, as per their planning, original asset allocation would enable Aman to reach his goals in a very sound and smooth manner, Tactical Asset Allocation provided him an area where he could tap an opportunity.

With this opportunity, Aman’s portfolio now had 40% in equity, 20% in fixed income securities, 35% in commodities and 5% in cash. 15% of the portfolio now shifted from fixed income securities (10%) and cash (5%) to commodities – gold.

Had Aman strictly followed Strategic Asset Allocation, he would not have been able to capitalise on the opportunity present. Hence, Tactical Asset Allocation provides flexibility to take market calls as and when needed.

With this, now we head to third strategy of asset allocation.

Dynamic Asset Allocation

This particular strategy, may involve several portfolio adjustments over the short term to respond to market conditions. There is no target asset mix because allocations can be changed based on their assessments of current and future market trends. For example, if global market uncertainties result in sharp losses in the equity markets, investment managers may sell stocks and buy bonds because fixed income instruments, especially government-issued bonds, are considered low-risk and safe investments.

Wealth / Investment managers analyses market and economic trends to select and trade investments within the portfolio. They would aim to sell top preforming investments and buy undervalued assets (following the buy low, sell high principle of investing).  The goal is to achieve the best returns possible with the aim of out preforming the benchmark. It is considered more risky compared to other strategies as with more risk comes more returns. However, dynamic asset allocation could underperform market averages, especially in volatile markets, because of high trading costs associated with frequent portfolio rebalancing.

However, the key difference is asset allocation here depends on market conditions rather than risk profile of the investor which is the very case of Strategic as well as Tactical Asset Allocation.

Let’s take the example of Aman in this case, what if he chooses Dynamic Asset Allocation strategy over Tactical Asset Allocation strategy. How would the process differ?

With his original asset allocation of 40% in equity, 30% in fixed income securities, 20% in commodities – gold and 10% in cash. Aman and his wealth manager decide not to rebalance the portfolio unless there is a major shift in the market conditions.

After 3 years from original allocation, Aman’s portfolio now stands at 55% in equity, 30% in fixed income securities, 10% in commodities – gold and 5% in cash.

Aman’s wealth manager advises him, according to the market conditions it is better to sell equity and gold and buy fixed income instruments. Since, equity levels have gone up, his wealth manager wants to be safe and protect his money incase of any equity market correction. Also, since the gold is held in demat form, it can be sold and be in instruments that are not extremely market linked.

One of the major characteristics of Dynamic Asset Allocation is to completely shift the original allocation and tailor make it to suit the current market conditions. Now Aman’s portfolio has just 10% of equity, 80% of fixed income instruments, 5% of commodities – gold and 5% of cash. As per the logic of the strategy, when the market will correct, Aman will be able to buy more of equity and gold without having any substantial effect on his investment portfolio.

In our next Thursday Trivia, we will cover specific questions which we have encountered over the years. Till then, in case you have any query please do write in the comment section below.

Please find link to our previous article – Thursday Trivia ~ Asset Allocation (Series 1 of 3)

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Disclaimer:  This particular series of Asset Allocation is only meant for educational purposes. We do not in any ways recommend it, as the case may differ for investors per se. These are simply model strategies of asset allocation, hence modification is required for each investor.

– Jinay Savla


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