Sunday, April 24, 2016

Multi-asset class investing - more important than security selection

There is a growing trend that investors should focus more on multi-asset class investing or the asset allocation decision over security selection. This is an important thinking for most investors. Don't worry about the elusive alpha. Focus on diversification and your betas. This is where the bulk of your returns will come from and where investors face the most risk. If you get the asset allocation wrong, investors will need a lot of alpha to make up for the difference.

One can view risk parity as one innovative approach to this allocation issue and factor-based investing as another solution to the problem. Risky parity says diversify across multiple asset classes but make the allocation through contribution to risk. Factor-based allocation looks at the underlying driver of the asset class. The general scheme is to move away from security selection and focus on sector selection. This can be done either on an active or passive basis. 

Certainly there is a mismatch of resources in asset management concerning this issue. A recent writer, Pranay Gupta, noted that 80% of the resources goes to security selection even though it may represent only 10-20% of the returns for most portfolios. The research shows that strategic asset allocation is more important even though it does not get the resource focus. The driver of portfolio performance in the first quarter was based on the ability of investors to hold more stocks after the announcement for more liquid monetary policies around the world than any security selection.

The difficultly of the problem does not change the result that asset allocation matters. Some may view that it is harder to predict or manage the beta risks for asset classes, but the movement to factor-based risk premiums allows for multi-class asset allocation that is diversified and manageable.  In a broad sense, global macro hedge fund strategies attempt to dynamically address the issue of asset allocation. 

The multi-asset question is more consistent with how investors think about making investment choices. Most investors do not think about the excess return of stocks versus the risk free rate. The discussion is focused on whether equities will do better than bonds, or whether credit will do better than Treasuries, or emerging markets will do better than developed market stocks. The context of most investment choices beyond the security selection is relative to another asset class. Hence the focus on asset classes is imperative. 

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