December 22, 2015

Your Asset Allocation Guide: Achieving long-term strategic targets

Setting long-term asset allocation targets in a portfolio and achieving them are two different things. Here we discuss portfolio drift and how to manage it.

When we construct portfolios with a strategic asset allocation, for example 70% in defensive assets and 30% in growth assets, it is very easy for the actual allocation to drift away from the long term strategic targets and for the risk of the portfolio to shift away from the targeted risk.

Factors affecting portfolio movements

Rises or falls in asset prices (e.g. share price rises), the generation of income and capital movements in and out of the portfolio can drive this. In addition, dynamic asset allocation recommendations, (e.g. as outlined in the table below) impact the exposure to asset classes by underweighting or overweighting asset classes.

The blend of all these factors is that a client’s actual portfolio may look quite different to the original design. For example a client wanting a conservative portfolio with 70% invested in defensive assets may find that the actual weights at a particular time resemble a higher risk portfolio with only 55% in defensive assets.

Managing portfolio drift

Portfolio drift and dynamic asset allocation decisions away from the long term strategic benchmarks therefore need to be managed very carefully so that the medium term risk and return characteristics of the portfolio don’t change dramatically. Although there are no hard and fast rules around rebalancing, portfolios should probably be reviewed and rebalanced once or twice each year.

Any more frequent and the portfolio may incur unnecessary transaction costs and tax liabilities, and any less frequent allows portfolios to further drift out of line, particularly in strongly trending markets.

Another approach is to use regular capital contributions, income and withdrawals as an opportunity to bring portfolio weights back into line. Additionally, the size of underweight and overweight recommendations to asset classes need to be made in the context of the risk of the portfolio – it is probably not appropriate to suggest that a portfolio with a 70% long term exposure to cash and fixed income go 10% underweight in fixed income and 10% overweight in equities.

Smaller active bets or portfolio tilts eg 2-3% are more appropriate for this type of portfolio whereas an aggressive portfolio with an 80% allocation to equities could comfortably accommodate a dynamic tilt recommendation to move to 90% equities without altering overall risk materially.

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