Asset allocation

Asset allocation

Asset allocation is a frequently referred to – and commonly used – important term in the investment arena, specifically referring to how an investor’s money is allocated to the underlying assets used in the construction of an investment portfolio. The most common asset classes are:

• Equities: (i.e., shares on the stock exchange).
• Bonds: governments or corporates need to raise capital and loans are created and sold either to the public or asset management houses.
• Cash: money market funds and fixed deposits are good examples of this.
• Property: generally unitised portfolios of corporate property (industrial and office type properties) being let out by a holding company.

Alternative investment strategies used by hedge fund managers, (commodities, crypto currencies, leveraged trading in equities and bonds) form part of a wider range of asset classes that could be used in the construction of an investment portfolio.

A further element to consider when undertaking asset allocation is that the asset classes can be accessed in your local investment markets, as well as in overseas markets. This adds an additional dimension of currency exposure to an investment portfolio.

An investment portfolio will usually have a goal or target allocation for each type of asset or asset class. The amounts set as targets are determined based on the investment objective of the portfolio. In general, a portfolio targeting higher returns over longer periods will have higher amounts allocated to growth assets and lower allocations to defensive assets. These terms are defined further below.

An investment manager will set the target allocations based on long term expectations of how an asset type or class is likely to perform. This target is known as Strategic Asset Allocation (SAA). The SAA of a portfolio is ultimately responsible for determining or explaining the largest portion of the investment return delivered over many years and is a far more significant decision than the choice of investment manager for an asset class.

Market returns are often driven in the short term by human emotions as well as temporary changes in the flow of available investment capital (money) on a global scale, rather than on fundamentals. This short term sentiment often drives the price of assets temporarily out of line with expected value – resulting in assets that are either more expensive or cheaper than they ‘should’ be.

This phenomenon in investment markets has resulted in the ability for investment managers to change their allocation on a short-term basis. This positional change in asset allocation is known as a Tactical Asset Allocation (TAA). TAA is used to either increase returns or reduce risk dependent on what the investment manager is trying to achieve.