Asset allocation vital for performance

Asset allocation is a key driver of performance. That doesn’t mean it’s not important to actively seek to generate alpha at specific asset class level. However, our focus is to get the asset allocation decision right – and it’s that decision that is most likely going to lead to a fund achieving its investment objective.

So how does the process work when setting up a fund? When investing, the starting point is to ensure that the investment objective of a fund is in line with the long term strategic objectives. Once the investment objective is defined, the benchmark can be set to meet that investment objective at worst, and to outperform it over time.

The investment manager must then structure the portfolio of assets in the best way possible to meet the objective. In that way members of the fund, trustees and the manager are all aligned in their performance expectations.

At Prescient we are very cognisant of the benchmark and try to generate outperformance where possible. A specific focus is on downside risk management – especially valuable during volatile markets such as the current investing environment – where we attempt to structure the portfolio of assets not to underperform the benchmark over time.

Risk is often defined as volatility. However, that’s not always an accurate description. We define risk as not meeting the investment objective. Volatility can be good! Essentially there are two aspects to volatility: upside volatility and downside volatility. Our belief or approach to managing money is to capture upside volatility while reducing downside volatility. In this way the fund is in a position to benefit from compounding positive returns.

Once the benchmark is defined, portfolio construction is essentially an optimisation process where we try to maximise returns, given a downside constraint. Asset allocation looks at the pricing or risk-adjusted valuation of assets, rather than relying on some spurious forecasting technique. The portfolio is then structured to benefit from the realisation of such value, with downside risk management techniques employed in case the value becomes more entrenched or set (the market falls) and is not realised in the timeframe considered.

Asset allocation in balanced funds can vary substantially with equity exposure varying from zero percent to 75 percent, offshore between zero percent and 25 percent for retirement funds, and the balance in bonds and money market. We have in the past five years actually reduced equity exposure in a downward market to zero percent and at times had it at 75 percent.

Most managers traditionally rely on stock selection to generate performance with asset allocation to a large extent a function of how the market has recently moved. In our view, however, asset allocation dominates performance.