Welcome to Part 1 of Ray Griffin’s paper on top down asset allocation modeling. In this 2 part series Ray walks you through the process of developing investment portfolios using a disciplined methodology designed to achieve a return on investment, along with portfolio risk management.
At any time asset allocation is centred on the two key themes of seeking a return on capital and investment risk management. It’s a given that people recommending investments are being asked to do so on the presumption that they are able to identify suitable investments for clients; selections which are otherwise superior decisions to what the investor herself would make.
Simultaneously, the typical investor is seeking – no matter to what degree – a component of risk management within the overall recommendations. Regardless of how ‘risk averse’ an investor might claim to be, there’s nothing like a market rout to remind them that losing all their capital is very undesirable.
Broadly speaking there are two primary approaches to portfolio asset allocation – the top down (macroeconomic to microeconomic) method and the ‘bottom up’ allocation model. The latter is generally predicated on the asset allocator’s view that, despite overall trends and conditions, investing in undervalued/mis-priced stocks will add alpha to portfolio returns. This paper will not debate these methodologies but will address a process for developing a top down methodology for application in an adviser’s day-to-day practice.
No doubt you’re hearing a lot about asset allocation – in early 2013 everyone seems to have an opinion and not all will be correct. However, when all the random noise of multi-channel commentary is cleared away, under a top down approach, advisers are able to develop a view of the world and then begin a process to make appropriate recommendations for clients. It’s never been easy but in 2013 it comes with such a complex array of conflicting indicators, that it really is a tough gig being an asset allocator.
Thousands of papers have been written and opinions proffered over very many years on asset allocation modeling; from Harry Markowitz’s much-cited Efficient Frontier thesis in his 1952 paper, Portfolio Selection, to the latest opinion from a media finance personality. Arguably, there is no single methodology which is superior for each will have there moments to shine. Indeed, some studies suggest blended top down/bottom-up allocations strategies have merit.
However, for the purposes of this paper, discussion is restricted to top down asset allocation for a ‘balanced’ portfolio. Yes, balance is in the eye of the asset allocator but please bear with me – the key issue here is the process of making decisions around asset types and their weightings in portfolios.
This paper does not attempt to provide an in depth technical analysis of myriad asset allocation theses in academia; rather it aims to provide financial advice practitioners with an insight into a practical approach to building investment portfolios premised on top down asset allocation methodology.
The conflicting components of asset allocation in 2013
Consider these contemporary (at the time of writing) conditions and their impact on asset allocation:
Australia
Low inflation – low interest rates and trending lower(?)
Modest GDP – modest unemployment
Modest corporate debt to equity ratios
Modest sovereign debt to GDP
Falling business confidence – relatively stable consumer confidence
The rest of the world advanced economies
Low inflation – very low interest rates
Low GDP (recessions?) – high unemployment
Weak but graduated improvements in corporate debt to equity ratios
Very high sovereign debt to GDP
Low business and consumer confidence
The above aspects are the headline environments within which asset allocators are practicing in 2013.
1. ‘Begin at the beginning’
It is perhaps very tempting for practitioners to move straight to selecting individual shares or managed funds for portfolios. The so-called hunch, or hot tip, is what brings investors undone every day and yet I’ve seen enough evidence over the years to know that advisers are not necessarily immune from such temptation. It fails a disciplined, considered, top down approach to investment selection.
In order to enhance the opportunity for top down asset allocation to lead to successful investment selection, advisers must have a deep understanding of world economic conditions; it is the beginning of a disciplined approach which applies whether advisers recommend managed funds or direct assets such as shares and property. Looking beyond broad economic and market issues, there is also a need to be cognisant of fiscal and monetary policies at play around the world, especially those within the major economies.
An understanding of global conditions provides insight into how certain classes of assets might behave in the foreseeable future. Granted that no one can foretell the future, a worldview is nevertheless the starting point.
Start with the RBA Chart Pack
In terms of gathering information about international economies and markets, one very sound starting point is to access the RBA’s ‘Chart Pack’ which is downloadable, at no cost, each month following the RBA Board meeting. The macro information which is available with the pack is extremely helpful in understanding where economies and markets are at and where they might be trending. http://www.rba.gov.au/chart-pack/index.html
Then there are resources available through the central banks of other economics such as the Federal Reserve Bank in the United States which can provide additional information about world economic conditions. While all such data is subject to interpretation, it nevertheless will provide asset allocators with the information from which to begin forming an opinion about global and domestic conditions.
2. Growth and income – where from?
The very essence of a balanced portfolio is to apply a spread of asset sectors within the portfolio in order to balance potential outcomes both on the upside and the downside. Essentially and to state the seemingly obvious, the spread, or ‘balance’, is an outcome of how an asset allocator views the world.
So in 2013 and notwithstanding that the future is largely unknowable, with such a mixed bag of economic data across the globe, where will you find sustainable long-term growth and consistent, reliable income for portfolios?
3. Domestic versus international weightings
This leads directly to the initial question of what level of international exposure, if any, should a portfolio have in the present conditions? While as is always the case, there will be exceptions to broad trends both in terms of individual economies and individual investments, the key issue is what outcome are you hoping to achieve versus the likelihood of that occurring in current conditions?
By default, once the proportion of the portfolio exposure to international assets has been determined, the remaining exposure is to domestic assets.
Some questions to ask?
• Is it likely that international exposure will provide growth in the foreseeable future?
• What income is likely to be derived from international exposure?
• What about currency movements?
• What might the trend for the AUD be and how might that impact on portfolios?
• Should the international allocation be hedged or part-hedged back into Australian Dollars?
4. Domestic macro conditions
With the remainder of the portfolio, allocated to Australian based assets, broadly the questions are:
• Interest rates
o Up? Down? Steady?
• Equities
o Priced for fair value?
o Overpriced?
o Undervalued?
• Listed/Managed Property
o Occupancy rates?
o Developments in the pipe-line and subsequent floor space
o Debt/equity ratios
o Fund geographic/ (city/country) exposure
o Business/Consumer confidence
• Fiscal and Monetary Policy
Looking more broadly, there is a range of macroeconomic issues that need to be considered including: consumer and business confidence, business investment, credit growth, construction, inflation and employment growth.
If looking to make recommendations for direct investments, an understanding of the macro data enables opinions to be formed on weightings to sectors within sectors. Once a weighting to domestic equities has been determined, in then falls to asset allocators to decide which sectors to target and the weightings. For example, consumer discretionary assets versus non-discretionary.
It then follows that decisions on equity sector weightings leads to the task of identifying the preferred companies within, for example, the banking sector.
Let’s just recap on the top down methodology:
Top down asset allocation
In effect, top down asset allocation could be described as a hierarchical process wherein the overriding determinant in portfolio outcomes is the allocation to market sectors.
In Part 2, we’ll look at the next steps in asset allocation along with stress testing of portfolios.
Note: The accreditation for this CPD article is no longer current. Please visit our CPD section for current CPD quizzes.
