Three Key Decisions in Formulating an Asset Allocation Strategy

Managing a multi-asset strategy portfolio is much more complicated than putting together a puzzle. There are three important stages in the process: asset allocation strategy, portfolio construction, and performance evaluation. In addition to the primer on multi-asset strategies, I'll share some practitioners' insights with you about each of these stages in a separate post. This is the first installment where I’ll focus on the formulation of an asset allocation strategy.

So what are the most important considerations in this stage? At an AsianInvestor conference in Beijing last year, I asked a panel of experts from some of the world’s largest institutional investors (including Korea’s sovereign wealth fund Korea Investment Corporation (KIC), Second Swedish National Pension Fund – AP2, and Russell Investments) for their opinions. They shared three key decisions they all had to make in formulating an asset allocation strategy.

1. The first question is what pieces should go in the puzzle — in other words, what asset classes should you include?

KIC started with a mostly global equity and fixed income portfolio in 2005. Since 2008, their mandate gradually expanded to include alternative investments, such as hedge funds, infrastructure, private equities, and real estate, explained former CIO Dong Ik Lee.

Tomas Franzén, chief investment strategist at AP2, told us that the fund started up over 10 years ago. Its policy portfolio now includes emerging market debt and equities as well as alternative investments (private equity, real estate, timber and agriculture, alternative risk premium, and alternative credit).

My Take: The textbook answer to this question is that everybody should have the same pieces, with size (total assets or total net worth) being the only difference. In reality, however, investors have different levels of risk tolerance and home country bias. They tend to start from the low end of the risk spectrum and stick closer to home, and then move towards a global portfolio. People generally begin with domestic stocks and bonds, then transition towards international, first with developed markets and then emerging markets. Many institutional investors have also gradually added alternatives exposures in recent decades.

2. How active should the portfolio be?

There is no single right answer to this question. Investors will have to look at their own circumstances.

Whether active management can add value has been a perennial debate. As Franzén put it, “Pure alpha is divine. And it’s quite expensive as well.” As a result, AP2 has been increasingly relying upon enhanced index strategies to get market exposures and some other well established drivers of return, especially in more efficient markets.

But many have not given up the fight entirely. KIC initially adopted a quantitative approach with low tracking error but has more recently started trying to add extra return by hiring research staff and becoming “more creative,” in Lee’s words. AP2 also realizes the value of active managers in particular asset classes. For example, they believe that Qualified Foreign Institutional Investor (QFII) is strategically better than investing in H-shares, and that they need good external managers based in the region. These managers enjoy more freedom to deviate from the benchmark.

My Take: Unless you have proven skills investing directly or in identifying external managers who do, (enhanced) indexing seems to be the natural solution.

3. Should you manage the money yourself or use external managers?

“When expanding outside of Sweden, we hired external managers, which turned out less successful than we hoped. We have since developed tilted indices and took assets in-house using a quantitative process. The exception is alternatives, all [are] managed externally,” said AP2's Franzén. Similarly, KIC outsources about a third of its publicly traded securities and all alternatives.

Scott Anderson, head of equity research for Japan at Russell Investments, discussed their manager search process. “We try to understand qualitatively [ . . . ] their approach on top of conducting quantitative analysis of performance data and see if they are consistent. In particular, we screen for poor performance and see whether that can be explained by the philosophy.” Anderson believes that it is important to distinguish between luck and skill. “Being contrarian and delivering solid performance is a good indication of skill," Anderson added.

My Take: Unless you have proven skills investing directly, hiring external managers seems to be a natural solution. And unless you have tremendous skills in trading operations and/or running extremely large sums of money, you should not even be doing your own index investing since the top vendors in the business would have a tremendous cost advantage.

Answering these three questions correctly should be sufficient in getting you started in managing your multi-asset strategy portfolio, be it an institutional fund or your retirement money. For more advanced discussions, stay tuned for the next two installments in this series.

For another great source of practitioner insights on our website, you can search all CFA Institute publications or use the advanced search option and limit your search to Conference Proceedings and Research Foundation publications in which we document the wisdom of some of the best and brightest in the industry.

For more in-depth coverage of these topics, Multi-Asset Strategies: The Future of Investment Management is available to CFA Institute members.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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