1.1 Overview of Asset Allocation

1.1.1    Role of Asset Allocation in Portfolio Management

• The main role of asset allocation in portfolio management is to specify and control the investors exposures to systematic risk
• Asset allocation combines capital market expectations – return, risk and correlation – with the investors’ expectations – risk, return and constraints as stated in Investment Policy Statement (IPS).
• Each asset class in its own quantifiable systematic risk, thus asset allocation seeks to establish a desired exposure to systematic risk using specific weights to individual asset classes.
• Asset class is grouping together of relatively similar investments in terms of their systematic risk factors e.g. long term corporate bonds, equities etc.
• Having/assigning specific proportions of exposures to specific asset classes enables managers to monitor and control their systematic risk exposure.
• Asset allocation thus connects realistic market expectations to the investors’ objectives and constraints.
• The weightings helps identify when the portfolio’s risk – return profile shift significantly away from the investors IPS and need to be reviewed/rebalanced.

1.1.2    Strategic versus Tactical Asset Allocation

• Strategic asset allocation is a conscious effort to gain desired exposure to systematic risk by matching market expectations and investor’s expectations.
• Strategic asset allocation (SAA) is long term in nature and the weights are called targets. The portfolio represented by SAA is known as Policy Portfolio ( also called target portfolio or benchmark)
• Tactical asset allocation (TAA) is temporary shifts allowed in order for managers to respond to alterations in short term capital market expectations.
• TAA is thus an active management strategy that is used by managers to deviate from the SAA in order to take advantage of perceived short term opportunities in the market as they seek to earn alpha return.
• Tactical asset allocation thus introduces additional risk above the systematic risk.

1.1.3    Importance of Asset Allocation in Portfolio Performance

• Strategic asset allocation (SAA) is the prime determinant of return (performance) explaining over 90% variability of total portfolio returns.
• TAA forms a small increment in returns.
• Asset allocation (SAA) serves both the client and manager in defining allocation based upon systematic risk factors that are in tandem with the client’s IPS (objectives and constraints).

1.1.4   Steps Involved in Establishing an Appropriate Asset Allocation

1. Formulation of an Investment Policy Statement (IPS) – Investment process starts with an analysis of the investor’s risk-return objectives and constraints.
2. Capital Market Expectations (CME) Formulation – The manager considers his opinion on the risk-return characteristics and correlations of the market.
3. Asset allocation – This involves determining respective asset class weightings given investor’s IPS in light of CME.
4. Monitoring and rebalancing when allocations shift from the Strategic Asset Allocations (SAA) – The assumption is that the SAA is an optimal allocation, thus the manager must ensure the portfolio matches SAA.