This article appeared in the June 2010 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
By Nerida Cole, Dixons
As the June 30 deadline approaches, it is a critical time to review tax planning strategies and asset allocation of investment portfolios.
Research shows correct asset allocation accounts for more than 80 per cent of a portfolio's return, with the remainder attributable to the selection of individual securities. Yet concerns about costs, tax implications and a range of investment biases cause many investors to neglect the disciplined portfolio re-balancing necessary to maintain a prudent and well-structured portfolio.
At its most basic level, asset allocation involves splitting the pool of investable funds between different asset classes to achieve desired investment objectives. Over recent years, the traditional asset classes of cash, domestic and international equities, fixed interest and property have evolved and now also include commodities, alternative investments and resources.
The way an investment portfolio is split between each asset class will determine characteristics of the portfolio, such as volatility, income, growth and security of capital. Ultimately, these characteristics involve trade-offs and investors who choose to diversify their portfolio will be able to construct a portfolio combining all of these elements at a level suited to their risk appetite and return objectives.
The shares and cash equation
Consider shares and cash, the asset classes most commonly used as a proxy for growth assets and defensive assets respectively. Shares historically have strong levels of growth over the long term, but have high volatility and a greater chance of loss of capital relative to other investment classes. At the opposite end of the scale, cash has minimal chance of capital loss, low volatility but no growth in capital value because returns are only in interest payments.
By allocating 100 per cent of a portfolio to either asset class, an investor will wholly experience the advantages, as well as the disadvantages, of the chosen asset class. However, by blending the portfolio to include a mixture of shares and cash, an investor could expect lower levels of volatility, lower risk of capital loss and a lower rate of growth compared to a portfolio comprised solely of shares. Compared with a 100 per cent cash portfolio, the blended portfolio would be expected to have higher volatility, increased chance of capital loss and an increased rate of growth.
Strategic asset allocation (SAA) is the most commonly used method to set asset allocation. This involves selecting a long-term mix of asset classes to achieve the investor's desired return within the required timeframe and with an acceptable level of risk.
Tactical asset allocation (TAA) involves weighting the investor's portfolio towards the asset classes expected to perform well in the short term (usually less than a year). Although much less common than strategic asset allocation, TAA can complement this technique by generating out-performance at the margin.
Conservative and assertive strategies
Consider a conservative retiree who relies on their portfolio to provide a reliable source of income to cover living expenses, and while concerned about inflation eating away the purchasing power of this income, they are more concerned about the damage capital losses would have on their financial situation. An appropriate strategic asset allocation would involve a very low exposure (no more than 15 per cent) to growth-focused asset classes, with the balance allocated to defensive asset classes.
In contrast, a young single investor with a desire for strong capital growth, no need for investment income and a willingness to bear the risk of some capital loss, may be classed as assertive, because they have a greater appetite for risk. An appropriate strategic asset allocation for an assertive investor may include a very high exposure (more than 75 per cent) to growth-focused asset classes and a very small amount to defensive asset classes.
Importantly, the work of a prudent investment manager does not end with allocating investable funds in line with the preferred strategic asset allocation. Investors need to regularly review the actual weightings to each asset class, compare this to the target levels and, if necessary, re-balance their portfolio back to the desired weightings.
Asset classes that perform well will tend to grow in value and the portfolio will end up skewed towards the high-performing asset classes. This is a particular issue for allocations to shares in strong markets.
Consider a balanced investor holding a portfolio of Australian shares riding the 'bull' market leading up to the global financial crisis. Without regular re-balancing, this portfolio would have been significantly overweight in shares and would therefore have suffered an unintended exposure to the market collapse.
Re-balancing is generally undertaken either at a specific time, either monthly, quarterly or annually, irrespective of how far the portfolio has drifted from its target position, or when a trigger event occurs, such as a particular asset class deviating from the target allocation by more than three per cent.
Revisit your original objectives
Investors need to be aware of the tax position of their portfolio because re-balancing can create tax liabilities, particularly from capital gains if profitable investments are sold. While some investors hesitate to take profits, the discipline of re-balancing allows the risks of the portfolio to be brought back to a manageable level.
Investors should also check with their investment adviser because brokerage costs may apply. Overall, the benefits of an appropriately weighted portfolio will generally far outweigh the additional costs and administration associated with re-balancing.
Careful planning by directing distributions and dividends into another asset class rather than accepting re-investment plans can also facilitate re-balancing strategies. Buying into an asset class via regular contributions such as salary sacrifice and dollar-cost averaging, will also help investors to sell high and buy low, averaging out the cost of each investment and reducing the overall volatility of the portfolio.
Revisiting the original reasons for selecting the preferred asset allocation and implementing a disciplined re-balancing strategy, ensures the balance between risk and return is appropriate and keeps investors on track to achieve their desired investment goals.
About the author
Nerida Cole is executive director, financial advisory, at Dixon Advisory and Superannuation Services.
ASX Exchanged Traded Funds (ETFs) are an increasingly popular, low-cost tool to re-balance portfolios each quarter. Learn more about the features, benefits and risks of ETFs, and how they can be used in portfolio construction and maintenance.
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