Asset allocation is a strategy to balance risk and returns by investing in different asset classes. Historical price movements of different asset classes like equity, fixed income or debt and gold show low or negative correlation among these asset classes. Hence diversification across asset classes can greatly reduce risk and generate potential superior returns in the long term. Financial planners suggest that right asset allocation strategy is critical in achieving your financial goals.
There are 3 broad types of asset allocation strategies:-
In Strategic Asset Allocation strategy, the fund has static asset allocation mix. The static asset allocation mix in practical terms for mutual funds is usually a range, allowing the fund manager some freedom to manage the asset allocation within the specified range e.g. 65 – 75% equity and 25 – 35% debt. The fund’s mandate establishes what the ideal asset allocation mix should be and the fund sticks to it, irrespective of market movements. However, from time to time, asset rebalancing is required to maintain the mandated asset mix.
Due to price movements of different assets, the actual asset mix may deviate from the mandated mix from time to time. The fund manager then rebalances the portfolio to bring it back to its mandated asset allocation mix. For example, let us assume that the mandated Static Asset Allocation is 70% equity and 30% debt. Let us assume that stock market rises by 25% and debt gives 6% return – the asset allocation then will be 73% equity and 27% debt. The fund manager will sell stocks and buy bonds to bring asset allocation to 70% equity and 30% debt.
Strategic asset allocation is akin to buy and hold strategy in stocks and bonds. One of the main advantages of strategic asset allocation with rebalancing strategy is that it enforces discipline in investments. If you stick to your strategic asset allocation irrespective of market movements, you will not make wrong investment decisions arising out of greed and fear. You should remember that static asset allocation is a long term strategy. Strategic allocation with high allocation to equity can cause portfolio volatility, but in the long term can reduce risk and help you meet your investment objectives.
One of the criticisms of Strategic Asset Allocation is that it seems too rigid. From time to time, market conditions may create opportunities to get extra returns which a rigid static asset allocation strategy may not be able to capitalize on. Tactical Asset Allocation is a variant of Strategic Asset Allocation strategy wherein the investor can occasionally deviate from the long term Strategic Asset Allocation to take advantage of market opportunities.
Tactical asset allocation calls for market timing and requires considerable investment expertise. For example, your strategic asset allocation requires you to maintain 70% equity and 30% debt mix. At a certain point of time, you think that equity can give high returns in the short term. You will tactically increase your equity allocation to 80% temporarily till you think that equity valuation is too high. The extra 10% allocation to equity will boost your returns in the short term. It is extremely important in Tactical asset allocation to know when the short term opportunity has run its course and promptly rebalance back to target strategic asset allocation.
One of the most common Tactical Asset Allocation strategies is momentum based strategy. Momentum can cause stock prices to rise rapidly in a short period of time boosting your short term returns. Identifying momentum stocks and assigning higher weights to them in your tactical asset allocation is an example of momentum based strategy. Tactical asset allocation is also applied within asset classes. For example, a fund normally intends to invest 50% in large cap, 15% in midcap and 35% in debt. If the fund manager thinks that midcaps are very attractive and poised for a rally, he / she might tactically, reduce position in large caps and increase in midcaps and then revert back to the intended asset allocation.
In this asset allocation strategy, you continuously adjust your asset allocation mix depending on market conditions. The most common dynamic asset allocation strategy used by mutual funds is counter-cyclical strategy. These funds increase their equity allocation (reduce debt allocation) when equity valuations decline (become cheaper) and reduce debt allocations. This is also known as contra strategy – it essentially follows the investment tenet of buying low and selling high. Different fund managers use different valuation metrics for dynamic asset allocation, the most common being P/E and P/B ratios. Some fund managers use multi-factor asset allocation models which combine 2 or more factors e.g. P/E, P/B, Dividend Yield etc. in dynamic asset allocation strategy.
Though dynamic asset allocation based on counter-cyclical or contra strategy is the most common strategy by dynamic asset allocation funds, other asset allocation strategies are also used. A few dynamic asset allocation funds follow a pro-cyclical strategy. The funds increase their equity allocation in rising markets and reduce it in falling markets. Some fund managers believe that following the trend is a good strategy which has worked in the past. Then there are dynamic asset allocation funds, which combine both approaches in what they call, core and tactical approach. The core portfolio (usually 70 – 80%) follows the typical valuation based counter-cyclical dynamic asset allocation strategy, while the tactical portion follows a momentum based approach, which is not dissimilar to the pro-cyclical strategy.
It is difficult to compare performance of strategic and dynamic asset allocation based funds across different market conditions and come to a definitive conclusion. Top performing funds across both categories have given good returns. Equity oriented hybrid funds with strategic asset allocation strategy usually outperform in bull markets, but they tend to be more volatile than dynamic asset allocation funds in volatile markets / market corrections. While dynamic asset allocation funds have been more stable / less volatile than strategic asset allocation based aggressive hybrid funds, aggressive hybrid funds have usually outperformed over longer investment periods.
In this article, we have discussed about different types of asset allocation strategies. Each strategy has its pros and cons, and is suited to different investment needs and risk profiles. Advantages or disadvantages of different asset allocation strategies notwithstanding, having an ideal asset allocation strategy in your financial plan is better than investing on an ad-hoc basis. Investors should discuss their financial goals and different asset allocation models and strategies with their financial advisors and make informed decisions about what is right for their investment needs.
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