Asset allocation: insights from our expert
Asset allocation is one of the most important functions a SMSF trustee performs.
It’s this process – deciding the correct split between the major asset classes such as equities and fixed interest, as well as the right exposure to emerging asset classes such as alternatives – that helps provide diversification and address risk in the portfolio.
The first step in the asset allocation process is to form views about how individual asset classes are likely to perform and look for opportunities in the asset classes that have the greatest potential to deliver good returns. It’s also important to consider risk management as part of the portfolio construction process.
When it comes to identifying investment opportunities, we live in a world of extremes. Some markets that have been out of favour now offer value, while other areas of the market are expensive and crowded.
The issue that investors are facing at the moment is that the most defensive parts of the market are also the most crowded. This makes diversification challenging; it’s no longer possible to rely on traditional portfolio construction processes. Rather, it’s important to use an approach that suits current market conditions.
Nevertheless many investment opportunities remain. An example is emerging market equities. Accommodative central bank monetary policies have benefited mainstream equities, particularly US equities. Concurrently the value of emerging equities markets in countries such as Russia and China have dramatically declined over the past five years. Therefore, there are many opportunities in developing countries to profit as these markets recover.
It’s essential to objective analysis when making asset allocation decisions. At AMP Capital, we look at many different factors that drive markets.
We look at market through 5 lenses: Value; Earnings and economic cycle, monetary policy and liquidity; sentiment; and technical drivers. If markets are overly optimistic about an asset class, it's negative for us, and when there's excessive pessimism it's positive.
So when there is substantial trading volume through one asset class and expectations are very high, we think that's risky. But if there is pessimism and volumes are low that could be a buying opportunity. For instance in early 2016 there was extreme pessimism around emerging markets. We saw that as an opportunity to buy assets at reasonable prices.
We also use fundamental analysis to ensure that when we take a position in a market that is undervalued, asset values don’t continue to substantially decline. This is when it’s important to factor earnings indicators and monetary policy decisions into our thinking.
SMSF investors can take a similar approach. So rather than making investment decisions based on what’s in the news, the idea is to look behind that to underlying data sources and form opinions on this information.
The challenges of asset allocation
One of the main challenges of asset allocation is putting in place protection around the assets to reduce the risk of a market correction negatively impacting the value of the overall portfolio.
We can use tools such as options as protection in a portfolio, especially when they are inexpensive. Typically, when volatility is very low, the cost of options is also low. At those times we take the opportunity to protect our portfolio through these instruments, which act like an insurance policy over the portfolio.
Even though this means we give up a small amount of return, it allows us to take advantage of new investment opportunities as they arise, without worrying about putting the rest of the portfolio at risk.
This is especially important in a market that is characterised by low growth and volatility. In more normal trading conditions underlying fundamental backdrop drive trading decisions. But trading away from the fundamentals has characterised many markets ever since the financial crisis of 2007/2008. Market declines becomes self-fulfilling, especially at crowded areas and selling encourages more selling.
This demonstrates how important it is to listen to the market and use insurance and protection as an overlay to a diversified portfolios. This can be difficult for self-managed super fund investors to achieve by themselves. Which is why it makes sense to invest with fund managers that have the ability to do this at scale.
Ultimately, great asset allocation is not just about having a view about markets, it's about also putting all the right ingredients together, including risk management tools, to achieve the an investment goal. This should be the aim for all investors, be they professional fund managers or SMSF and self directed investors.
About the author
Nader Naeimi, Head of Dynamic Markets at AMP Capital. He is also the portfolio manager of the Dynamic Markets Fund.
Access up to 80 global opportunities in a single trade
In a world where market volatility and low growth are the new norm, asset allocation is more important than ever. However accessing asset classes globally and outside of the usual places in order to do this is difficult.
AMP Capital’s Dynamic Markets Fund (Hedge Fund) ASX Code: DMKT, an exchange traded managed fund, offers a low cost solution to global portfolio diversification with a real return objective.