Asset allocation is an integral part of the portfolio management process.
In a plain-vanilla portfolio, this strategy refers to allocating assets between stocks and bonds. In a somewhat complex portfolio, the strategy includes alternative asset classes such as commodities and art.
Empirical evidence suggests that asset allocation substantially contributes to portfolio returns.
Given the importance of the process, this article discusses two simple, yet powerful asset allocation strategies that professional money managers employ. Individual investors can replicate both these strategies with help from their investment advisors.
One is the constant mix strategy and the other, the constant proportion strategy. The former outperforms during market reversals while the latter does well in trending markets.
Asset allocation
In a seminal paper published in 1992, William Sharpe showed that the asset allocation process could explain nearly 90 per cent of the variability in returns for a mutual fund. It is no different for individual portfolios.
In a seminal paper published in 1992, William Sharpe showed that the asset allocation process could explain nearly 90 per cent of the variability in returns for a mutual fund. It is no different for individual portfolios.
This does not mean that security selection is not important. If one were to explain portfolio returns in terms of excess returns (alpha) and market returns (beta), the security selection process generates alpha while the asset allocation process generates beta.
Suffice it to know here that it is important for investors to pre-determine their portfolio composition between stocks and bonds (or term deposits).
Constant Mix Strategy
This strategy maintains constant equity exposure as a percentage of the total assets. Suppose the investor has Rs 10 lakh and decides to have 60 per cent equity exposure. The initial portfolio will, hence, have Rs 6 lakh in equity and Rs 4 lakh in bonds.
This strategy maintains constant equity exposure as a percentage of the total assets. Suppose the investor has Rs 10 lakh and decides to have 60 per cent equity exposure. The initial portfolio will, hence, have Rs 6 lakh in equity and Rs 4 lakh in bonds.
What if the equity portfolio thereafter declines 10 per cent? It would be worth Rs 5.4 lakh, 57 per cent of the total assets of Rs 9.4 lakh.
To have an equity exposure of 60 per cent, the investor would have to buy shares worth Rs 24,000 and sell equivalent value of bonds.
Next, consider what happens if the equity portfolio moves up 10 per cent to Rs 6.6 lakh.
The total portfolio would be worth Rs 10.6 lakh. The portfolio would have to be rebalanced, as 60 per cent of Rs 10.6 lakh is Rs 6.36 lakh. The investor would, therefore, have to sell Rs 24,000 worth shares and invest in bonds.
The Constant Mix strategy plays on the behavioural psychology of investors.
The reason is that it engages in value-buying by increasing equity exposure when stock prices decline. The strategy also helps investors take profits quickly, as it cuts exposure when stock prices move up.
Constant Proportion Strategy
This asset allocation strategy requires the investor to define a floor and a multiplier. Portfolio Management Services firms in India use similar process to manage their capital guaranteed products.
This asset allocation strategy requires the investor to define a floor and a multiplier. Portfolio Management Services firms in India use similar process to manage their capital guaranteed products.
Suppose an investor has Rs 10 lakh which she wants to allocate between stocks and bonds. Assume a floor of Rs 8 lakh and a multiplier of 2. The difference between the total assets and the floor is called the “cushion”. The equity exposure is a multiple of the cushion.
In the above example, the cushion is Rs 2 lakh. With a multiplier of 2, the initial equity exposure will be Rs 4 lakh. The balance Rs 6 lakh will be typically invested in bonds or term deposits.
Suppose the equity portfolio declines 10 per cent. The total portfolio would be worth Rs 9.6 lakh and the equity exposure permissible is Rs 3.2 lakh [2 (Rs 9.6 lakh- 8 lakh)]. This means that the investor would have to rebalance the portfolio - sell Rs 40,000 worth of equity and invest in bonds.
What if the equity portfolio moves up 10 per cent? The total portfolio would be worth Rs 10.4 lakh. The cushion would be Rs 2.4 lakh, which allows an equity exposure of Rs 4.8 lakh. So, the investor would have to sell Rs 80,000 worth bonds and invest in equity.
Conclusion
The Constant Mix strategy buys more equity when prices go down and sells as prices go up. This continual buy-and-sell strategy helps investors take advantage of reversals within a range-bound market. The strategy underperforms when the market is trending up or down, for the same reason that it does well on reversals.
The Constant Mix strategy buys more equity when prices go down and sells as prices go up. This continual buy-and-sell strategy helps investors take advantage of reversals within a range-bound market. The strategy underperforms when the market is trending up or down, for the same reason that it does well on reversals.
The Constant Proportion strategy loads more equity into the portfolio when the market moves up and reduces exposure when the market moves down. It is precisely for this reason that the strategy outperforms in a trending market-higher equity exposure will generate more returns when the market is up and lower exposure minimise losses when the market is down.
What about rebalancing the portfolio when stock prices drift? That is a trade-off between the rebalancing cost and the drift from the pre-determined portfolio composition. Investors may wish to rebalance their portfolio at least once every year.
B.Venkatesh
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