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Advanced Asset Allocation Strategies

| Money Rates Columnist.
min read

man-pen-writeWhat does the ocean have in common with asset allocation?

Every ocean has waves, which are peaks and troughs of energy. The waves build higher and lower and, over time, they move forward.

Waves of energy also form peaks and troughs in the various stocks, bonds and cash investments you select for your portfolio. The energy rises and falls to different degrees, gathering momentum and moving through the markets at different speeds like waves do too.

Investors can do little to stem the tide of market developments - which have the potential to devastate one's portfolio - but they can learn to channel the movement of energy waves through the process of asset allocation.

The goal of asset allocation is to produce a diversified portfolio comprised of assets that increase in value over time, but at a risk level that meets the needs of the investor.

Top takeaways from this article:

  1. Recognize the types of risk affecting your portfolio
  2. Learn about four types of asset allocation
  3. Understand how mutual funds and ETFs can help you diversify

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Identify Risks to Your Portfolio

Risk is an inherent part of any investment. There is always the possibility that an investment will decline in value.

One way to help prevent a decline is to identify the risks, then develop a plan to minimize their effects on your overall portfolio.

Many investors acknowledge the idea of risk, but they may not be clear on what investment risk is.

What is investment risk?

"Investment risk" describes the variability of achieving a specific investment return. Essentially, it's a term used to discuss the deviation between the expected return on specific investments and the actual return.

Few investors can identify how many types of investment risk can affect their portfolio. At any one time, a portfolio faces:

Principal risk: the chance the money you have invested will decline in value.

Credit risk: the chance a borrower will default on an obligation.

Market risk: the likelihood of a broad investment market, such as the bond or stock market, will decline in value.

Liquidity risk: the possibility you won't be able to sell or convert a security into cash when you need the money.

Understand How Risk Works

Risk could be due to factors related to a specific investment as well as factors at play in the overall economy. Examples of economic risk include news about inflation, industrial production, employment, monetary policy, consumer sentiment and international events to name a few.

All of these factors influence stock and bond markets in different ways. By diversifying across asset classes, an investor can reduce investment risks that affect the variability of returns.

Diversifying can yield different results

Investors who diversify but limit themselves to a single type of asset class such as small-cap stocks, for instance, assume more risk than those who invest across different types of asset classes.

Also, while it is counterintuitive, sometimes adding a risky asset to a portfolio actually can reduce the portfolio's overall risk. When you add a risky asset to a portfolio, it can be considered a form of hedging. Adding groups of riskier assets that are not in the core portfolio requires some advanced asset allocation decisions. But these decisions can be better made once an investor knows the types of risks facing their portfolio.

When the sources of portfolio risk are independent, and the portfolio is diversified through the asset allocation process, exposure to any one risk source should be reduced. However, even in a diversified portfolio, the risk is present in the form of market risk, which is the source of systemic or market-wide risk that cannot be diversified away.

Limitations of diversification

Diversification, however, is not free. Diversification can be considered a type of hedging strategy, accompanied by a cost in the form of some assets that are designed to act as a counterweight to advancing assets.

In any diversified portfolio, some assets will be gaining in price while others are decreasing. This is the trade-off in the risk-managed portfolio - but over time, the overall portfolio's gains should outpace declines.

Modern Portfolio Theory

Advanced asset allocation relies on ideas from Modern Portfolio Theory. This theory was developed in the early 1950s and used statistical analysis to prove that the overall risk in any investment portfolio can be identified and managed by examining the risk relationships between combinations of investments.

An essential part of this theory is that risk can be managed through diversification, and that better risk-adjusted performing portfolios can be built using combinations of different assets.

One landmark study found that asset allocation policy is so important that it is responsible for determining more than 90% of a portfolio's performance variability over time.

The basic idea of asset allocation is well-accepted today. Target-date funds and other professionally managed diversified portfolios are available as ETFs and mutual funds. They cover many risk levels and time frames and include a wide variety of underlying asset classes.

Investment managers use three main types of strategies to manage diversified portfolios:

  • Tactical asset allocation
  • Strategic asset allocation
  • Dynamic asset allocation

The strategies mainly differ in how quickly they react to market changes and their level of active management.

Tactical Asset Allocation

This strategy adjusts portfolios in response to short-term changes in the markets or to pursue an investment opportunity such as rotation from small- to large-cap stocks or a downturn in international markets.

TAA can also be used to adjust overall exposure in the pre-determined asset allocations that may have increased or decreased over time to bring them more in line with the owner's risk tolerance.

Strategic Asset Allocation

Strategic asset allocation makes portfolio changes based on a longer time frame. It has a more passive management approach and requires less trading.

Dynamic Asset Allocation

This is the most active form of trading and is used to re-allocate a portfolio due to changing market conditions as they present themselves.

Dynamic asset allocation requires frequent trading and rebalancing and is the most expensive type of the three asset allocation trading strategies.

Core-Satellite Models

While the three types of asset allocation strategies listed above cover the level and frequency of trading and need for active management, they still require a portfolio to manage.

This is where a core-satellite portfolio comes into the picture.

A core-satellite strategy uses a core portfolio holding complemented by satellite positions, often in other mutual funds or ETFs. This is a flexible strategy that can meet the needs of investors with a range of risk tolerances.

Core-satellite model examples

Investors with a higher risk tolerance, for example, can combine a growth portfolio with specialty mutual funds, ETFs, or alternative investments to increase the potential for total return.

For investors with moderate risk tolerance, a balanced portfolio can be combined with specialized equity or income-generating mutual funds or ETFs. The goal here is to provide the potential for capital appreciation and current income.

Tax-sensitive clients can use balanced or conservative growth portfolios with laddered municipal bonds or tax-exempt mutual funds to provide the potential for federal tax-exempt income with less risk.

Each core-satellite strategy can be supplemented with satellite positions in a variety of asset classes.

For instance, investors with higher risk tolerances can select ETFs in high-return market sectors and then sell those positions as that sector cools without disrupting the overall asset allocation strategy. The emphasis should be on managing the core portfolio and rebalancing to keep the overall asset class exposures and risk levels in line with the original investment goal.

Rebalancing to avoid drift (or overlap)

In this strategy and others, rebalancing is a critical part of any advanced allocation strategy due to something called "drift" or "overlap." This problem can be expensive and increase the risk to any allocation strategy, including the core-satellite approach.

The main reason is due to product overlap between using ETFs and mutual funds. By definition, ETFs are indexes comprised of different weightings in underlying stocks in a specific sector. When ETFs are combined with mutual funds, investors may find that, despite the different products, they hold many of the same stocks.

Style drift can be a problem for investors concerned about having specific fund investment-style percentages within certain asset classes. For instance, if your target diversification for small-cap funds is 10% and your small-cap fund grows into the mid-cap category, your fund diversification will fall well below 10%.

Investors can review the holding of funds quarterly, but ETFs indexes and their respective holdings are usually rebalanced annually. ETF rebalancing is a risk management tool, not a performance enhancer. However, investors managing their portfolios should rebalance in response to changing market conditions and changes in the holdings of underlying fund assets.

Expanding the Asset Class Universe

Advanced asset allocation uses different management strategies along a spectrum of active and passive management. However, advanced asset allocation also includes a much wider variety of other mutual funds and asset classes (equity, bond, alternatives) in its portfolio composition.

Examples of these other asset classes or funds that can be added to the advanced diversification mix are high yield funds, growth and income funds, growth funds, convertible securities, equity income funds, specialized equity ETFs and funds (technology, real estate, energy, ESG) and varieties of mid-, small- and large-cap growth and value funds.

Also, fixed income is part of this mix and can include investment-grade corporates, governments, mortgage, and asset-backed bonds, and high yield bonds. Further, the bonds can come in a variety of credit ratings and maturities.

The Role of Leveraged ETFs

One of the newest additions to the ETF world is leveraged ETFs. These are offered by some ETF firms and allow investors to magnify price moves in any ETF by up to three times the daily or monthly price moves of an index.

Leveraged ETFs carry more risk, require more supervision, and should be used by more sophisticated investors. However, they present easy market access to capitalize on short-term market opportunities and may have a role in a core-satellite strategy.

Advanced Allocation Can Reduce Risk

Thanks to Modern Portfolio Theory, there are several different mutual and managed funds today that can deliver a diversified portfolio of investments in a single fund.

The very popular target-date funds are a good example of a diversified portfolio that adjusts risk levels as the investor approaches retirement and their portfolio becomes more conservative. Combining asset classes is essential in any advanced asset allocation strategy. How many funds and ETFs are selected depends on the investor's risk level, time frame, and the size of their portfolio.

Modern Portfolio Theory is over 50 years old, but the idea of linking risk to return created new advanced asset allocation and risk management strategies. For investors, it is now possible to quantify a portfolio's risk level, so investors can create portfolios at all risk levels to meet their investment goals. It has also allowed other investors to expect a higher return if they assume more risk, and that simple idea has re-shaped investing.

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