The new asset allocation

In Vision Focus: Rethinking Asset Allocation, State Street illustrates how the traditional idea of allocating assets for a fixed amount of time is being shunned by investors in favour of a more tactical approach using frequent risk analysis. The events of 2007 – 2009 have raised questions about long-held tenets of asset allocation, including investors’ reliance on portfolio construction and risk models centered on average market behaviour and normal return distributions.

“The financial crisis exposed the need to understand the limitations of traditional practices such as modern portfolio theory (MPT) and heightened the need for new approaches to strategic and tactical asset allocation,” says Dan Farley, global head of the multi-asset class solutions group with State Street Global Advisors. “Thanks to lessons learned from this period, many investors have gained a more nuanced reminder of portfolio risks centring on market volatility, portfolio construction and trading liquidity.”

New challenges
Due to the credit-driven nature of the financial crisis and the resulting liquidity shortage, State Street recommends that investors enhance their allocation process with optimal rebalancing. And because non-normal investment returns and dramatic swings in valuation may continue to occur over the next few years, investors should give new consideration to within-horizon risk, investment regimes and turbulence.

The report defines within-horizon risk as the risk of portfolio elements breaching a predetermined threshold at any time during the investment horizon.

“As a consequence, strategic allocation—normally associated with beta and long-term risk premiums—and tactical allocation—normally associated with the pursuit of alpha—are blending into a more holistic process,” the report says. “To effectuate this, investors are increasingly turning to global macro hedge funds, effectively outsourcing their tactical asset allocation.”

And, as research continues into investor behaviour, viewing the data in aggregate in order to understand investor sentiment—particularly investors’ tolerance for risk—makes it clear that regimes dictate behaviour and that this behaviour has a quantifiable impact on asset-return characteristics.

The report explains that better understanding of turbulence can also help investors plan for contingencies during specific market conditions.

“Turbulence may arrive randomly, but once it begins, it takes time to get through the systems. As markets encounter one of their 10% most turbulent days, the likelihood of that turbulence continuing over the next five, 10 or 20 days is substantially larger than during normal times,” the report says.

The concept of MPT is not dead, says the report. In fact, it is arguably more relevant than ever as risk management moves to centre stage. And while investors have many methods of optimization—including classic mean variance—to manage risk, the increasing occurrence of outlier events means that they may be forced to “optimize their optimization.”