Updated: May 20
Just like in any industry, the world of investing has its own particular terminology and taxonomy. Nowhere is this more apparent than in multi-asset investing, particularly asset allocation. To recap, the term ‘asset allocation’ refers to the decision about which asset classes to invest in and the relative weightings to these.
"A new breed of funds has entered the market"
There are a number of terms referring to aspects or styles of asset allocation. Some are beyond the scope of this article, but broadly speaking, asset allocation strategies for multi-asset funds can be categorised into three key groups: those that adhere strictly to fixed pre-set weights (strategic asset allocation), those that can deviate a small extent from these weights (tactical asset allocation), and those that, from time to time, shift asset allocation a great deal (dynamic asset allocation). Let’s look at each of these three strategies in more detail.
Strategic asset allocation (SAA)
In SAA, the decision as to how the portfolio will be weighted to various asset classes is set at the outset and rigidly adhered to. Funds managed using this strategy aim to outperform a composite index (generally comprising bonds and equities) over a certain period through security selection alone. For example, a common practice is for a ‘growth’ multi-asset fund – suitable for those with a long investment timeframe – to be managed against a 70% equities/30% bonds index. A ‘conservative’ multi-asset fund – suitable for those in late stage retirement – may be managed against an index that comprises only bonds and cash.
SAA can be expected to achieve a fund’s objective over the longer term, based on the expected returns for each asset class. These expected returns are generally based on actual historical averages over the medium to long term and, since long-term historic averages change little from year to year, SAA tends to be very static. Once the SAA is set, the portfolio is periodically rebalanced back to the fixed pre-set weights to take account of market movements within each relevant asset class.
Tactical asset allocation (TAA)
This strategy is used in conjunction with SAA, in that a base asset allocation is set at the outset but, in this case, asset allocation can be altered as market conditions change.
Its purpose is to add value in the short term to the strategic, longer-term exposure of the fund. To use a racing analogy, strategy is your broad pre-race plan of how you intend to achieve the ultimate objective of finishing the race in the best possible time. It is predetermined and, if well-founded, should not change much from race to race. Tactics are the manoeuvres you make during a race in response to the conditions and specific events taking place at the time, such as the moves and actions of your competitors.
Applying this analogy to the world of investment, if it has been determined that a strategic weight (SAA) of 70% equities/30% bonds would achieve a fund’s long-term goals, but equity markets have risen sharply over the last two months, a fund manager might expect them to fall back, and so could temporarily reduce the equity weight from 70% to 65%.
They could then either increase the allocation to bonds by 5% or leave the proceeds in cash until the decision is made to reinvest and move back to the pre-set weight for equities. TAA should be thought of in terms of pairs of decisions that, in combination, add value to the portfolio over the short to medium term.
The first decision is to move away from the SAA weight, either in one or more steps, while the second decision is to move back towards the SAA weight.
Dynamic asset allocation (DAA)
In recent years, a new breed of funds has entered the market. DAA funds do not aim to outperform a composite index, but aim to generate a particular return or outcome, say 5% above inflation per annum (known as a real return), over a certain timeframe.
DAA funds have no pre-set weightings to particular asset classes. So as opposed to the smaller asset allocation moves under TAA, these funds are able to move away sharply from their normal allocation to take advantage of, or provide protection against, prevailing market conditions or the macroeconomic outlook. This flexibility is a key feature of DAA, as a more static asset allocation strategy would fail to deliver a particular outcome – or real return – if either bond or equity markets fell substantially.
Another feature of DAA funds, which helps in managing to a defined outcome, is that the pool of assets is typically much broader than those managed under SAA strategies. Since shifting asset class weights are decisions that should rightly be expected to add value, it is reasonable to expect that outcome-based or real return-oriented multi-asset funds should generate better risk-adjusted returns. However, it is important to keep in mind that the success of these strategies is highly dependent on the ability of the fund manager to add value through their asset allocation decisions.
Which style of fund you choose – whether it is a traditional SAA fund or an outcome-based multi-asset fund employing DAA, or a combination – will depend on a number of factors, including your investment objective and timeframe as well as your attitude to risk. A financial planner can play an important role in aligning your objectives and goals with the most appropriate investment strategy for your stage in life and circumstances.
Published in Aberdeen marketing
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.