Does asset allocation work?

InvestorWords.com defines asset allocation as the process of dividing investments among different kinds of assets, such as equities, bonds, real estate and cash, to optimise the risk/reward trade-off based on an individual's specific situation and goals. “It is a key concept in financial planning and money management,” says Dr Prieur du Plessis, Plexus group chairman.

There is no simple formula to find the right asset allocation for every individual,” says Du Plessis. However, most financial professionals agree that asset allocation is one of the most important investment decisions.

“Your selection of individual securities is secondary to the way you allocate your investment in equities, bonds, real estate and cash. The division among assets is the principal determinant of your investment results,” says Du Plessis.

Modern Portfolio Theory is a theory about how risk-averse investors can construct portfolios to maximise expected returns based on a given level of market risk, emphasising that risk is an inherent part of higher reward. According to the theory, pioneered by Harry Markowitz, it is possible to construct an ‘efficient frontier’ of optimal portfolios offering the best possible expected return for a given level of risk.

Asset allocation funds attempt to provide investors with portfolio structures that address an investor's age, risk appetite and investment objectives with an appropriate or optimal apportionment of asset classes. At inception of the portfolio, a ‘base policy mix’, namely the long-term strategic asset allocation of the fund, is established based on expected returns.

“As the value of assets can change due to market conditions, the portfolio constantly needs to be re-adjusted back to the strategic asset allocation. This ensures that the risk and return profile of the fund remains the same,” says Du Plessis.

According to Du Plessis, determining a strategic asset allocation for a portfolio is not as simple as it sounds, as expected returns cannot be based purely on long-term historic averages. Current valuations, the economic cycle and future prospects for the asset classes should also be taken into account.

“Perhaps tactical asset allocation is the most important factor in determining the success of an asset allocation fund,” says Du Plessis. This strategy allows portfolio managers to create extra value by taking advantage of certain situations in the market place, such as pricing anomalies or expected strong outperformance from certain asset classes.

“The manager will overweight the asset classes expected to outperform and underweight those expected to underperform. Itis normally a moderately active strategy since managers return the portfolio to itsoriginal strategic asset mix when the desired short-term profits are achieved or the overweight asset class becomes overvalued,” adds Du Plessis.

The most important question is how successful managers are at making tactical asset allocation decisions. Research conducted by Plexus Asset Management on the returns of various domestic asset allocation funds over one, five and 10 year periods ending 29 February 2009, which is close to the most recent market bottom, reveals some startling facts.

According to Du Plessis, the asset allocation funds that can reduce equity exposure to zero, namely the prudential low equity, prudential variable equity and flexible funds, provided little protection against the sharp decline in equity prices during the past year.

“Of the 37 prudential variable equity funds, only one achieved a positive return over the one-year period,” says Du Plessis. “Of the 51 flexible funds, only four realised positive returns.”

“It is difficult to draw conclusions over five and 10-year periods as many funds moved from the prudential high and prudential medium equity sectors to the prudential variable equity sector, which was created in September 2007,” says Du Plessis.

Of significance is that the flexible funds, which can also allocate up to 100% of their portfolios to equities, generally underperformed the prudential variable equity sector, which can invest up to 75% in equities. Furthermore, not one of the asset allocation sectors outperformed the general equity fund sector, which delivered 14,3% and 14,7% on average over five and 10 years up to 29 February 2009 respectively.”

“Based on these findings, investors must realise that the wider the investment mandate and the more aggressively the portfolio manager pursues it, the greater the chance of the manager not achieving the investment objective,” says Du Plessis. “The manager could shoot the lights out, but the manager could also make serious mistakes.”

“It is imperative for investors to understand the manager’s objective and the investment strategy being followed to achieve this. If you are uncertain, rather choose a fund that has the necessary restrictions in place in line with an asset allocation that suits your investment objectives and risk profile,” says Du Plessis.