How Many Different Approaches to Asset Allocation Are There?
What Really Drives Performance?
What should I invest in? How much should I put in stocks versus bonds? Should I investigate alternatives? Is it better to focus on one specific ratio? Should an algorithm hold more weight for success than the opinion of a financial manager? Dynamic Alpha Solutions understands that the investment universe is complex. We aim to simplify that dynamic investing world, turning opportunities into value through what we call Multi-Dimensional Asset Allocation.
A crucial component of investment is asset allocation – the formula used for a mix of investments that balances risk and rewards. Our commentary on how an asset allocation is like a cookie recipe goes into our philosophy on building Multi-Dimensional Asset Allocation portfolios. To some, it may seem as though asset allocation is a giant game of chance – but it truly is a carefully designed formula that financial managers create based on client’s needs, creating the optimal mix of assets that will maximize the return for any given level of risk – ultimately leading to a smoother investment experience.
Our blog post, “ABC’s of Investment Fund Analysis” discusses risk further, but we know that a manager’s strength lies in his or her ability to assess goals, risk tolerance, time frame, investment experience, and knowledge that would impact the recommended type of asset allocation.
How does Multi-Dimensional Asset Allocation choose where to allocate funds?
We believe there are three main asset allocation methodologies – strategic, tactical/dynamic/flexible, and alternative. They are each successful and limited in their own way – that is why we created our unique Multi-Dimensional Asset Allocation approach, which combines these differences in a specific way to help ensure portfolio success.
The strategic asset allocation model is a traditional buy-and-hold approach. A manager allocates a fixed amount to specific asset classes that include predominantly stocks and bonds, and periodically rebalances that portfolio to the original allocation.
The tactical asset allocation is more flexible as the name suggests. This approach utilizes a variety of asset classes generally including stocks and bonds, but with the ability to increase or decrease the allocations to those categories. Within tactical asset allocation, we view three main disciplines used to help guide the manager on what asset classes or over or underweight. Quantitative, Fundamental, & Technical Analysis can all be used to help guide the tactical changes.
It sounds confusing, but once you see it applied, it is easier to understand.
A traditional strategic asset allocation may invest in a 60:40 split where the manager would put 60% of the funds into stocks and 40% into bonds. Those ratios are checked and rebalanced to ensure the percentages of those allocations consistently remain the same.
On the other hand, a tactical allocation may target a similar 60:40 split, however, the management style of the allocations can deviate by certain amounts during specific and planned opportune times. Market timing – which impacts the ability to move investments in or out of the market or switch asset classes based on predictive methods – plays a fundamental role in this tactical approach.
The typical understanding of market management means that most people believe that the ideal method requires someone to get out at the top of the market and to jump back in at the bottom, however, we believe that isn’t always necessary to outperform.
Many investment firms sell the buy-and-hold approach utilizing this chart below which illustrates that if you miss the 10 or 20 best days, your return would be much lower.
Mathematically, that sounds logical; however, what is seldom shown is what happens if you miss the 10 or 20 worst days?
The chart below demonstrates an exponential difference.
Are we saying one can invest in such a way to miss the worst days altogether? Absolutely not. Timing the market perfectly is nearly impossible. What we are saying is that if one misses some of the best days and misses some of the worst days, you might not get out at the top, but you may get out near the top. Similarly, you won’t get in at the bottom, but you might get in near the bottom.
The chart below shows returns if you missed the 10 or 20 best and worst days. The returns are slightly better than if you had stayed invested, however, the volatility experienced is dramatically different – that is the key!
The psychology of investing is one of the key determinants of investing success – and that is how we achieve our goal of a smoother investment experience!
Finally, the third approach is alternative asset allocation. It utilizes strategies designed to be noncorrelated to traditional asset classes. Normally, alternative investments would mean things like real estate, gold, and commodities; however, Dynamic Alpha Solutions takes an ‘alternative to alternatives’ approach. We include strategies that do not fit easily into any other category – including market-neutral income strategies that can be viewed as bond alternatives.
But asset allocation is more than simply managing ratios and predicting the market; it is the constant evaluation of performance. So, what drives that performance?
With the strategic allocation approach, it is the overall market – stocks or bonds – that will determine performance. With tactical allocation, the skills, methods, and disciplines of the manager can have a much greater impact on overall performance. In an alternative allocation, the returns are designed to be noncorrelated with traditional stocks and bonds.
We at Dynamic Alpha Solutions believe building Multi-Dimensional Asset Allocations requires taking all three approaches into consideration – increasing the likelihood that one of them will provide positive returns. In a future blog titled, “It’s All Relative Performance, … or is it Absolute?” we will further discuss these types of returns.
So, what are they using to make these decisions? Let’s look.
Fundamental research is conducted by a team of economist-strategist portfolio managers who utilize a disciplined process to make decisions about buying or selling under- or overweighted areas. Their focus is on the data, but because a human is making the decisions, there is a chance that human error, bias, or emotions may drive a decision – however, that isn’t always bad.
For example, if a manager notices a trend in a certain area where they see the potential for growth, they may allocate more toward that sector or investment; however it may take time for that vision to come to fruition.
Quantitative research is produced by a computer algorithm designed by economist-strategist portfolio managers to evaluate data points. The key distinction with a quantitative approach is that the algorithm in many cases is making the buy/sell decisions in the portfolio. This does generally take human emotion out of the equation, which could be good or bad.
While an algorithm seems safe on the surface, we are acutely aware that errors could exist in the program, or certain data points may have been omitted or misunderstood by the algorithm. For example, the computer program may not understand the potentially short-lived ramifications of COVID on specific areas of the market. Additionally, data also can be late, all the variables might not have been thought of during the program production, or a model could be built just to “fit the curve,” and not for the bigger picture.
The technical analysis primarily employs investment charts examining price change, moving averages, support, and resistance. Analysts look at past performance as a possible indicator of future trends.
After considering both fundamental and quantitative research strategies as well as technical analysis, we at Dynamic Alpha Solutions value a multi-dimensional approach. Combining a wide range of asset classes with multi-faceted research and analysis provides the smoothest return experience possible.
The table below references what happens in different types of markets:
The three columns above demonstrate the different asset allocation approaches. The three rows illustrate the different market performances one could experience (Up, Flat, or Down).
You can see that with the strategic allocation approach, one is essentially at the whim of the market’s direction in terms of controlling performance. Certainly, risk tolerance can play a role, but the overall market (be it stock or bond) is in control of the returns.
In the tactical allocation column, we can see that performance is more dependent on the success of the approach taken by the tactical managers. We like to say a tactical manager, gives us a fighting chance to perform.
With an alternative allocation, the returns are designed to be noncorrelated, and we can see that they could go up or down relative to the traditional stock and bond markets, as they are driven by their own market and/or their own unique strategy.
Dynamic Alpha Solutions takes care to ensure that each of our allocations to these different approaches is diverse in discipline, background, and approaches. By simultaneously utilizing all of the methods and disciplines available, we are able to provide our clients with a smoother experience and simplify the seemingly complex world of investing.