Understanding Asset Allocation

Introduction to Asset Allocation

The oft cited landmark study “Determinants of Portfolio Performance,” written by Gary Brinson, Brian Singer, and Gilbert Beebower, demonstrated that the asset allocation decision is the most critical element leading to investor success. The article demonstrated that the investor’s selected asset allocation can account for approximately 91.5% of a portfolio’s rate of return. This finding underscores the asset allocation decision as the most critical element leading to investor success. [1].

Asset allocation is the process of dividing an portfolio into different asset classes. These asset classes include domestic equities, global equities, bonds, cash, and alternative assets. An investor, working in tandem with the investment manager, selects an asset allocation designed to satisfy the investor’s goals, time horizon, and risk tolerance.

Benefits of Asset Allocation

The basic concept behind asset allocation is to optimize investor return and minimize risk within the parameters set forth by the investor. Investor managers achieve this optimization by utilizing projected returns for various assets and securities, historical volatility, and correlation measures between asset classes.

Adding different asset classes to a portfolio reduces market volatility because these assets do not react in the same way to economic events. The portfolio structure offsets the decline in the value of one asset class with a gain in another. The correlation coefficient measures the relative movement between assets.

Correlation Coefficients

The table below provides correlation statistics from 1988 to 2023

A correlation factor of 0.7 or less means that adding a different asset class or security to a portfolio offers diversification benefit. The MSCI-EM index correlation to U.S. markets is 0.6 and highlights that the relative movements between the two indices move in differing directions. In other words, adding Emerging Market assets to the S&P improves portfolio diversification. Investment Grade Bonds provide even greater diversification benefits, highlighting the value of investing in different asset classes.

Asset Allocation within Asset Classes

Examples of allocation by subclasses within equities might include by market capitalization, by country or region, or by sector. In fixed income investing investors can allocate by US or municipal government bonds, foreign sovereign bonds, US or International corporate bonds to name a few.  Fixed income investors can further allocate by duration.

For more information on the many ways that Hemispheres reduces risk and diversifies client we would refer you to Hemispheres Investment Management’s March 18, 2024, article “Strategic Diversification and Risk Management”.[2]

Strategies for Effective Asset Allocation

There are several types of asset allocation strategies based on investment goals, risk tolerance and time horizon. The most common forms of asset allocation are strategic and tactical asset allocation.

Strategic Asset Allocation

Investor goals, time horizon, risk tolerance, and unique circumstances establish and maintain target allocations for asset classes over time in a Strategic Asset allocation portfolio. We will illustrate this allocation method using a 60% equity and 40% fixed income allocation. After a period, because of appreciation in the equity portion of the portfolio, the allocation has become 65% equity and 35% fixed income. Strategic Asset Allocation would require sale of 5% of the equity class to rebalance the portfolio thereby maintaining the 60/40 level determined by the investor. Strategic asset allocation is essentially a buy and hold strategy that doesn’t change markedly with economic conditions. Rebalancing the portfolio is performed as necessary.

In periodic performance reviews, the investor is free to change this allocation as circumstances or preferences change.

Tactical Asset Allocation

A Tactical Asset Allocation is an active management investment approach that positions a portfolio into those assets, sectors, or individual stocks that show the most potential for gains based on market trends or economic conditions. Hemispheres manages client funds using Tactical Allocation also considering investor risk and return profiles. In addition to the allocation between major asset classes, the Hemispheres Global Equities strategy is diversified by region, by country, by sector and by individual securities where superior return potential exists.

Hemispheres invests opportunistically, utilizing a value style of investment. Value investing involves buying stocks below intrinsic value using metrics like price-to-book value, earnings multiples, and high dividend yields. The discount of the market price to the intrinsic value is what Benjamin Graham called the “margin of safety.” Hemispheres Investment Management analyzes these metrics, along with factors like earnings stability, asset quality, debt burden and market competition. The firm purchases high-quality companies at discounted prices. Buying industry leading companies at discounted prices is a proven method of reducing investor risk and generating long-term favorable returns.

Factors to Consider in Developing an Asset Allocation Strategy

Financial Goals: Cash Requirements

Stock and Bond markets are volatile, and the value of your investment capital changes frequently.
Your ability to withstand a temporary drop in the value of an investment is limited if you have a financial goal that requires capital in a few months’ time. The asset allocation should reflect this time horizon. Examples might include the purchase of a house where the investor is saving for a down payment. An appropriate allocation in this example would be a bond or bonds where the maturity matches the timing of your cash requirement. For an individual that is retirement planning, where fund withdrawals will not occur for 20 or 30 years, a more aggressive strategy is suitable.

Time Horizon

As mentioned above, the longer an investor has until cash is required, the more aggressive the asset allocation can be. An individual with 20 to 30 years until retirement for example can withstand multiple market cycles and would be well served to have a heavier allocation in domestic and international equities. A younger person with a longer time horizon and a higher risk tolerance may choose to invest in a greater proportion of small and medium capitalization companies than a person nearing retirement. These companies often offer disruptive technologies and early stages can be quite risky. However, successful adoption of these technologies can offer big returns over time to a patient investor. An individual nearing retirement may elect to increase portfolio allocation to large capitalization companies that are stable, dividend paying industry leaders or increase allocation to fixed income asset class.

The Benefit of a Global Equity Allocation

The Global Equity benchmark, the MSCI ACWI, had a United States country weighting of 63.2% on January 31, 2024. Globally, there are over 45 countries with investible stock markets. Not all countries have the same monetary and fiscal policies and those policies matter to foreign investors. Hemispheres can invest in over 10,000 market leading companies with market capitalization over $1 billion. These opportunities compare to 2,000+ in the US alone, providing higher diversification potential and enhanced returns.

Please note the returns in the table below. Hemispheres’ returns on almost all time periods were stronger than the Global Value Benchmark and the S&P 500. 

As shown above, US markets and Emerging Markets are not highly correlated. Kent Smetters, professor of business economics at Wharton School of the University of Pennsylvania, a proponent of passive index investing generally, noted that value can be found in emerging markets. He wrote: “But in certain niche markets, like emerging-market .…where assets are less liquid and fewer people are watching, it is possible for an active manager to spot diamonds in the rough[3].”  Hemispheres Investment Management’s Principals have over 35 years of experience managing portfolios for individual and institutional accounts with a deep proficiency in emerging market investing.

Risk Tolerance

All investing involves risk. There are many things that asset managers can do to optimize an asset allocation for an investor. Optimization looks at market return potential as well as diversification opportunities to smooth earnings over time. Despite best efforts however, unexpected events can result in deviation from forecasts. For this reason, it is important for an investor and an investment advisor to clearly understand one another. With very low risk tolerance, investors need to adjust asset classes with the understanding of a likely lower expected return potential, given the alternate asset allocation.

Monitoring and Adjusting Asset Allocation

In addition to receiving quarterly statements outlining your returns and your portfolio holdings it is important to communicate with your investment manager. Managing your investment portfolio requires regular, annual portfolio performance evaluations (reviews), which play a crucial role in ensuring achievement of investor objectives. The frequency of these reviews can occur more often if needed as a change in circumstance or investment objectives occur. During these meetings, participants determine the necessity or advisability of changing the asset allocation.  For information on the elements of a portfolio performance evaluation, please review to our article in the link below.[4]

Conclusion

Hemispheres Investment Management’s principals have over 35+ years of successfully managing client funds through multiple market cycles and various watershed events. Over time we have developed a proven and repeatable investment process with demonstrated results. We encourage you to contact us for a free consultation. We can assist you develop an asset allocation that is appropriate for your needs and preferences. Please feel free to book a free consultation with us.

[1] https://rpc.cfainstitute.org/en/research/financial-analysts-journal/1991/determinants-of-portfolio-performance-ii-an-update

[2] https://hemispheresim.com/strategic-diversification-and-risk-management-in-global-equities-investing/

[3] https://executiveeducation.wharton.upenn.edu/thought-leadership/wharton-wealth-management-initiative/wmi-thought-leadership/active-vs-passive-investing-which-approach-offers-better-returns/

[4] https://hemispheresim.com/portfolio-performance-evaluation-how-to-evaluate-your-global-equity-investments/