What is Strategic Asset Allocation?
Strategic asset allocation (SAA), as the name suggests, is a strategy that decides the allocation of various assets in the portfolio. Assets could be equities, fixed income, and cash. Not only that, the portfolio is rebalanced or adjusted to pre-decided asset allocation percentages. This is done when, over a period of time, due to different returns of the various assets, the weightage of these assets changes significantly.
Investor Preferences for Allocation
This approach of strategic asset allocation allocates the assets based on investor preferences about the following factors.
- What is Strategic Asset Allocation?
- Investor Preferences for Allocation
- Level of Allocation
- Modern Portfolio Theory and Strategic Asset Allocation
- Strategic Asset Allocation Process
- tolerance for risk and
- expectations of return
- investment horizon
As opposed to Tactical Asset Allocation, which targets a short or medium-term investment horizon, Strategic Asset Allocation is a long-term decision, typically spanning a decade or more.
Level of Allocation
Broadly, the asset classes can be divided into
- Fixed Incomes
But these can be further sub-classified into
- Small, Mid, and Large Cap
- Geographical classification
- Developed, Emerging Markets,
So, the portion of the investment in these broad assets and their sub-classification would depend on investor preferences.
Strategic Asset Allocation is based on Modern Portfolio Theory. Let’s briefly look at this basis and the relationship between the two.
Modern Portfolio Theory and Strategic Asset Allocation
Modern Portfolio Theory puts forth the hypothesis that investors can create portfolios that provide them maximum or optimum returns for a given level of risk. It also extolls the virtues of diversification, i.e., spreading a portfolio across asset classes and instruments.
Strategic Asset Allocation uses Modern Portfolio Theory as a base by using the efficiency of markets. It does so by determining an asset allocation based on risk tolerance and then sticking to it instead of trying to assess the direction of markets. This discipline is the cornerstone of the Strategic Asset Allocation approach.
Strategic Asset Allocation Process
Assessment of Risk
The Strategic Asset Allocation process begins with the assessment of the risk tolerance level of an investor. This is done in a detailed manner with the help of questionnaires and via discussions between the investor and the entity constructing the portfolio.
Another key input is the investment horizon, i.e., the duration for which an investor intends to keep the money invested in the portfolio.
These two inputs are key in determining the eventual portfolio and are used in tandem. For an investor with a high level of risk tolerance, higher exposure to equities may not necessarily be the optimal choice unless the investment time frame is also known. Thus, for a high-risk investor with a short-term time horizon, a more moderate equity exposure would be suggested than another investor with a similar tolerance for risk but a relatively longer time frame to remain invested.
Broad-Based Asset Allocation
After assessing an investor’s risk profile and discussing the investment horizon, an allocation to broad-based asset classes like equities, fixed income, and cash is made, keeping in mind the expected return of these asset classes given their levels of risk.
Further Allocation in Each Broad-Based Asset Classes
This step is followed by further breaking down these broad asset classes into categories divided into market capitalization groups, by geographical divisions, by analytical groups, or any other method. Similar to the broad-based asset classes, percentage allocation to these categories follows the next step.
Monitoring and Rebalancing
After the Strategic Asset Allocation is determined, it is monitored and rebalanced on a particular frequency like bi-annually or annually.
Let’s see how this works by an example.
Rebalancing in the Strategic Asset Allocation Process
Though Strategic Asset Allocation is akin to a buy and holds strategy, this is not to say that it is not monitored. Portfolio rebalancing ensures that after a pre-determined period, the entity managing the portfolio makes changes to the allocation. This is to ensure that the allocation to the broad asset classes, namely, equities, fixed income, and cash, is brought back to the level which was determined initially. This is required because the returns from these asset classes change the asset allocation, given their performance over the course of the period.
Example of Rebalancing
For instance, let’s consider an investor with $100,000 to invest. According to his risk tolerance level and investment horizon assessment, let’s assume that the Strategic Asset Allocation comes out to be 60% to equities, 30% to fixed income, and 10% to cash. This means that $60,000 of the aforementioned investment pool will be invested in stocks, $30,000 will be invested in bonds, and $10,000 will be invested in cash and cash equivalents. The rebalancing frequency has been fixed annually.
|Asset Class||Target Allocation(%)||Target Amount($)|
After one year, let’s assume that the equities portion of the portfolio has returned 20%, fixed income has returned 9.5%, and cash has returned 2.5%. This performance has increased the portfolio’s overall value to $115,100, with the value of equities, fixed income, and cash segments standing at $72,000, $32,850, and $10,250, respectively. But due to this change in value, the allocation of these asset classes now stands at 62.6%, 28.5%, and 8.9%, respectively, which is a deviation from the 60:30:10 mix that was determined initially.
|Asset Class||Target Allocation(%)||Target Amount($)||Current Amount||Current Allocation|
According to the initial asset allocation mix, the value of the equities segment should be $69,060, that of fixed income should be $34,530, and that of cash should be $11,510, given the new value of the overall portfolio. This means that $2,940 from the equities segment needs to be sold off, and the proceeds need to be used to buy $1,680 worth of bonds, with the remaining $1,260 being invested in cash and cash equivalents.
|Asset Class||New Allocation(%)||New Amount($)|
In this manner, rebalancing compels the investor to book profits from the segments which are doing well and redeploy to other asset classes.
Given the effectiveness of the diversification of a portfolio and the discipline that comes with investing in the Strategic Asset Allocation strategy, an investor can reap the benefits of a relatively low correlation between broad asset classes and securities comprising these asset classes over a long period of time. No particular asset class is expected to outperform the others consistently.