Asset allocation is one of the main concerns of portfolio management. Asset allocation answers several questions. What risk-return trade-off are we comfortable with? In other words, what level of risk are we willing to take to achieve a certain level of active return? At each level of active return there is an equivalent amount of risk. Many portfolio managers are judged simply on the performance they have achieved without further analysis of the risk they took to produce that return. This is why we have seen the arrival of rogue new merchants like Kweku Odoboli. These traders want to place positions that give a certain amount of return to meet their strict benchmarks.
Asset allocation can be done using alpha or beta drivers. Alpha drivers measure the manager’s ability to generate a so-called active return. Active performance is the difference between the benchmark and actual performance. Alpha is more aggressive and aims to achieve returns above established benchmarks. Alpha controllers are normally classified as Tactical Asset Allocation (TAA). TAA facilitates an investor’s long-term financing goals by seeking an additional return. It focuses on arbitrage in the sense that it takes advantage of unbalanced market fundamentals. TAA requires more frequent trading than Strategic Asset Allocation (SAA) to produce the additional returns.
Beta drivers are the more traditional investment techniques that aim to meet benchmarks. It involves the systematic capture of existing risk premiums. Beta drivers are used in the construction of SAA. This type of allocation crystallizes the investment policy of an institutional investor. This process highlights strategic benchmarks tied to broad asset classes that set policy / beta / market risk. This type of allowance is not designed to beat the market and must meet organizations’ long-term funding goals, such as defined benefit pension plans.
Wide classes of Alpha controllers
1. Long or short investment
2. Absolute return strategies (hedge funds)
3. Market segmentation
4. Concentrated portfolios
5. Non-linear return processes (payment similar to an option)
6. Alternative cheap beta (anything outside the normal stock / bond portfolio)
Typical asset allocation for an institutional portfolio
Equity 40%
Fixed income 30%
Real Estate 15%
Inflation protection 15%
Breaking down the equity portion
The strategic allocation to equities could be broken down into the following sub-classes:
Beta drivers – 60%
• Passive equity
• 130-30
• Enhanced index equities
Alpha drivers – 40%
• Private capital
• Debt in distress
Convertible bonds have a hybrid structure that is a mix of equity and fixed income securities, so they can be classified into either the equity or fixed income category.
Fixed income portfolio
This section of the portfolio can also be divided into alpha and beta drivers. The fixed income portfolio can be distributed as follows:
Beta drivers – 60%
• US Treasury Bonds.
• Investment grade corporate bonds
• Securities backed by agency mortgages
Alpha drivers – 40%
• Convertible bonds, high yield bonds and intermediate debt
• Guaranteed debt obligation (CDO) and guaranteed loan obligation (CLO)
• Fixed income based hedge fund strategies, fixed income arbitrage relative value, distressed debt
15% inflation coverage
This is an investment strategy that aims to provide a cushion against the risk of a currency losing value. Other investments can produce returns in excess of inflation, but inflation hedging is specifically designed to preserve the value of a currency. Here’s how you can divide the inflation coverage portion of your portfolio:
TIPS (Treasury Inflation Protected Securities) 20%
Infrastructure 20%
Raw materials 20%
Natural resources 20%
Inflation Oriented Actions 20%
15% real asset allocation
Real estate is a form of investment with limited liquidity compared to other investments, it is also capital intensive (although capital can be obtained through mortgage leverage) and is highly dependent on cash flow. Due to these realities, it is important that this section of the portfolio does not constitute the majority of the portfolio. You could structure your real estate portfolio in the following way:
Real Estate Investment Trust (REIT) 40%
Direct investments 30%
Real estate venture capital investment 15%
Specialized 15%
However, it is very important to note that option-like securities are very risky and should be used with extreme caution. This is what brought down the oldest merchant bank in the UK and is what Warren Buffet describes as “financial weapons of mass destruction”. Portfolio management should be done as conservatively as possible. This means that the majority of the portfolio must be strategic and the minority must be tactical. It is also very prudent to have limits on the alpha search positions an institution can pursue and have a waterproof internal control system to curb illegal trade.