Strategic Asset Allocation Is Important
Last time I discussed some of the basic asset allocation factors that will face a fund manager. This time, I am going to discuss some of the slightly more in depth issues. These are the strategic asset allocation decisions that are faced.
As with my comments last month, the same holds true for this: by trying to get an understanding of how a professional manages money, you, the individual can try to find elements to emulate and hopefully improve.
The points below would be more likely to relate to a pension fund manager than a unit trust / mutual fund manager. Why? Simply because most pension funds invest in a wide range of assets for diversification, as would many private investors. Many or most unit trust / mutual fund managers are forced to invest in the area in which their fund specialises. This might limit them to smaller companies on the NASDAQ or whatever.
The first decision any individual investor or fund manager must make is a choice as to which 'classes of assets' to add to a portfolio. The second decision is to ask what strategic proportions should be used over the longer term (5+ years).
This strategic asset allocation decision is focused on the average over time likely to be allocated to each asset class. This average needs to be chosen to enable any return objectives to be met. This goes without saying that it is easier said than done...
A fund manager might then make alternative tactical asset allocation weightings if he or she has strong views for or against a particular sector or asset. As you probably know, these tactical decisions are an important part of the world of international investment.
Lastly, the selection strategies must be chosen for each portfolio. This will usually involve the actual picking of securities. Ideally, the selection is looking for those securities that will outperform in the near term.
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I know, I know. I'm over complicating this terribly! We all know that the most important investment decision making process for any stock exchange is this:
'Meet friend in bar. Listen to story about a friend of a friend of a friend of the man in the bar who happens to have some 'hot' knowledge about something. Look in stock pages of paper. Company really exists! Call broker. Empty savings account buying all that can be afforded. Wait for fame and fortune to arrive.'
Ok, so I am being a little sarcastic there. But only a little!
Always remember that investment is a business. It is a big, big business that very bright people work very hard at and take very seriously. To be successful, you should do that too.
Anyway...
The strategic and tactical asset allocation choices and issues will determine the style of fund management. A portfolio that is built by only considering each security on it's own merits is created 'bottom up'.
As the computing power of fund managers increases, this is becoming less important as a style. So much more analysis can be completed now than say 15 or 20 years ago that reflecting fund liabilities is now far easier.
The asset allocation classes most commonly used are equities (in home and overseas markets), bonds, property, cash and bills. The fact that most funds are dominated by equities is really only a sign of outperformance over other assets.
Having decided upon asset classes, strategic weights will be assigned to each. These will be the central proportions upon which the fund is built. These decisions might be made on a geographical basis (eg more in Japan), to match liabilities (perhaps for a pension fund) or to copy other funds (yes really!). This is clearly going to be a 'top down' approach.
If a fund is built to match liabilities (the dates and amounts when payouts are required) then asset allocation is likely to change with time. As the workforce ages (in the pension scheme example) the asset mix must change into steadily safer and safer assets that are more liquid and less volatile.
Some funds simply follow the actions of other funds or are designed to maximise returns for a given risk level. Others are designed to follow certain parts (or all) of an index, in the case of tracker funds. All of these funds will have highly sophisticated computer modelling techniques which will have target strategic and tactical asset weightings.
If I am giving you the impression that there is a lot to this 'investment lark' then I consider that a good thing.
*This was first sent to my email subscribers in August 2006*
For other articles about related topics, please visit:
How To Copy A Fund Manager's Asset Allocation Techniques
Asset Allocation And Portfolio Management For Individuals
What Are The Two Main Fund Management Approaches?
What Is Portfolio Tilting?
Assessing Fund Performance
The Concentrated Portfolio
The Competitive Advantage / Business Franchise In Investment