Thursday 25 April 2013

Why Strategic Asset Allocation Is A Flawed Concept

Strategic Asset Allocation (SAA) is the current orthodoxy for portfolio construction. It involves building a portfolio with a set mix of assets based on a client's risk profile and goals.
For example a 'balanced' (medium risk) investor might be given an asset allocation as follows:
10% commodities,
30% equities,
10% property,
45% fixed interest,
5% cash.
As asset prices change given market conditions, the portfolio needs to be re-adjusted in keeping with the client's risk profile and policy objectives.

Whilst I agree that knowing a client's goals and attitude to risk are of crucial importance when dispensing advice, I don't think it good practice to consign a client to a mix of assets based solely on the outcome of this information. The following are reasons this strategy could prove detrimental.

1. This methodology fails to take into account the relative value of one asset class compared to another. For example during the dot com boom in 1999-2000, the FTSE 100 was trading at a PE ratio of 30 (over double today's value), anyone with a modicum of sense could see that equities were grossly overvalued, yet strategic asset allocation would have heavily exposed an 'adventurous' investor to this asset class resulting in subsequent catastrophic destruction of capital. While equities will always be volatile, it can be argued that investing in them when they are cheap (relative to earnings/net assets) is a lot less risky than investing in them when they are expensive.
As with the above example, the risk of any asset class can change with circumstance. For example it could be argued that long dated government bonds (typically a low risk asset) pose a far higher risk now than they did 7 years ago, before bond markets were subjected to QE intervention from central banks.
At a time when bank solvency is in question it might also be argued that the risk involved in holding cash has increased.

2. The re-balancing of a portfolio, to keep it in line with a clients risk profile, may lead to selling at a bad time. A popular piece of investment advice is to cut your losers and let your winners run. SAA is almost the antithesis of this strategy. Also if portfolios are being rebalanced too often, a hefty amount of trading costs will be incurred, thus negatively affecting returns.

3. People's attitude to risk tends to vary over time given their recent experience. For example clients who have just witnessed an extended equity bull market that has significantly increased their wealth are more likely to be more bullish when filling out a risk questionnaire, and if SAA is used they may be left with a high exposure to equities at a time when equities are overvalued.
Conversely if clients have just been subjected to a long period of negative returns during a recessionary period, they may well be more bearish when filling out a risk questionnaire, thus reducing the proportion of equities in their portfolio at a time when equities may represent very good value.

A variation on this approach is Tactical Asset Allocation (TAA), which allows a range for the percentage of capital in each asset class. For example the range for equities in a balanced portfolio might be 25%-35%. This approach allows an adviser some room to incorporate asset class valuation into the asset allocation strategy. The downside to this (and a big plus to SAA) is that many advisers are terrible at timing the market, and TAA brings the danger of human error into the equation.



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