Asset allocation never so critical

By Jon Reilly, Implemented Portfolios

Investors in 2012 are fortunate to have a broad range of tools available to them that enable asset class and investment exposures to be incorporated into a portfolio much more simply, transparently and cost effectively than just a few years ago.

It is five years since the onset of the global financial crisis and many investors have felt compelled to take a much more active interest in the management of their portfolio, either directly or by continuing to work with a trusted adviser.

One of the advantages of working with an investment professional is that they provide a disciplined approach to portfolio management, including regularly reviewing investment markets and assessing recent performance and likely future opportunities.

The relationship is inevitably more effective when the communication between investor and manager goes both ways. This in turn requires the investor to be familiar with some of the fundamental elements of managing a portfolio in the current environment.

One of the first discussions to have relates to your risk profile, and there are a number of ways to approach this, from online surveys and questionnaires to a more detailed analysis of your emotional capacity to handle risk and financial capacity to absorb market fluctuations.

Once agreed, the next step is to design a portfolio that is likely to achieve your identified objectives. This will ultimately mean making decisions about allocating the portfolio between various asset classes.

The investment industry uses broad categories to group different asset classes that can be expected to provide similar risk and return characteristics, often defined as income and growth assets. Cash, term deposits and fixed interest are typically termed income, while equities (Australian and international) and real estate (listed and unlisted) are considered to be growth assets.

For a portfolio invested across multiple asset classes, managing the initial allocation and the ongoing decisions to maintain or alter it, is critical to the performance in terms of risk and return.

Alternatives in managing asset allocation

We have all heard market idioms such as "it's time in the market, not timing the market" or, more simply, "buy and hold" in regard to volatile asset classes such as equities. Often such advice was accompanied by what is referred to as a strategic asset allocation, which meant setting an exposure to, say, Australian equities and then regularly rebalancing to that level when price movements caused a variance beyond the strategic allocation.

In the current environment, some investors, here and overseas, are asking how long they need to buy and hold to see the expected returns? In late September 2012 the ASX All Ordinaries index was at approximately 4400, the same level as in August 2005. Of course, the intervening period included much higher highs and much lower lows, and with the value of dividends over that seven years it meant investors still received an annual income return of 5 per cent.

With the benefit of hindsight, how many investors would have preferred to take a steady 5 per cent annual return instead of a gain of more than 50 per cent to November 2007, followed by a drop of more than 50 per cent to March 2009, and a recovery to breakeven on price terms seven years later?

Perhaps instead of income and growth, we should talk in terms of defensive and risky assets, and of course we need to think about what future years are likely to hold, instead of falling into the trap of fighting last year's battles. Sadly, it is all too common to hear of investors who took the full brunt of the downside, lost confidence and missed the subsequent recovery.

An alternative to the strategic asset allocation approach that has gained significant interest in recent times is a dynamic asset allocation approach. Typically, such strategies operate within much broader minimum and maximum ranges for each asset class, and probably include more substantial changes to the target exposures, based on forecasts for future investment performance. Such forecasts are difficult to develop accurately in short timeframes, but can be much more reliably developed over longer investment horizons.

In essence, if expected long-term future returns are not sufficient to compensate an investor for the additional risk being assumed, a dynamic asset allocation approach enables a portfolio manager to move substantially out of risky assets and into defensive ones. Referring to the example above, would you prefer a steady 5 per cent from mainly defensive assets or the rollercoaster ride in Australian equities that provided the same return over seven years?

Expanded investment range

The advent of exchange-traded funds (ETFs) on the Australian Securities Exchanges brought local investors a vastly expanded range of investment options, including simple access to markets that were once only available through institutional investment managers. Although this development is ongoing, already investors can source exposure to government and corporate bonds, a wide range of commodities, and international equities, as simply as buying shares in BHP Billiton or Commonwealth Bank.

Additionally, it means investors can take a view on a particular sector of the Australian market, or an international investment market, and buy that exposure simply, cheaply and transparently. There has been much research to support the conclusion that these asset allocation decisions, including at a sector and regional level, are the most important in determining your portfolio outcomes.

As an example, you may agree with several analysts who expect that Australian banks are unlikely to experience significant growth in the coming few years. However, dividends, including franking credits, providing a return of between 9 per cent and 10 per cent per annum look attractive to an investor who has had 5 per cent return overall in the past seven years.

There are a range of ETF investment options listed on ASX that enable an investor to access the return from the whole financials sector, rather than having to pick individual banks in which to invest.

Perhaps a starker example internationally is the developed markets such as the United States, Europe and Japan, compared with the emerging markets, which include China, South Korea, Taiwan, India and Brazil. In the former we have economies that are now, or soon will be, dealing with enormous debt, which will be a significant drag on economic growth for many years to come. A subdued growth, "muddle through" economy is perhaps an optimistic assessment, at least for the next several years.

By contrast, 90 per cent off the world's population lives in emerging markets, where economies are slowing but are continuing to grow at 5 per cent to 7 per cent per annum and where people have rising incomes and standards of living.

ASX now provides options for investors to access these economies directly, or to target the international companies that are expected to benefit from consumers with higher disposable income.

Conclusion

At the very least, the GFC should have given investors cause to reassess their risk profile and the composition of their portfolio, and just as importantly, the investment philosophy that will guide future decisions and underpin future performance.

We should expect that at some point there will be another market shock, or even another crisis. But for investors who understand the impact on the portfolio and the range of investment options available to them, there can be good opportunities to secure long-term returns.

About the author

Jon Reilly is chief investment officer of Implemented Portfolios, a leading portfolio construction and investment management company.

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