Asset allocation: is it enough?
An analysis based on asset allocation is a common way for advisors to measure risk in client portfolios. But simplifying risk at the asset class level can create blind spots in decision-making, especially for investors who own individual stocks. In fact, there is often a wide dispersion of risk between different holdings within an asset class that can go unnoticed without examining individual security risks.
When looking only at asset allocation, advisors are unable to dissect each position into its common performance drivers such as market beta, sector trends, style factors, interest rates , credit spreads, etc. It is these risk factors that really explain the sources of risk in a portfolio. For clients who have concentrated equity positions – often 5%, 10% or more of the total portfolio – it is extremely important to highlight these company-specific risks through bottom-up analysis.
Take Microsoft and Twitter for example. They are both large-cap technology companies in the S&P 500. If we were to perform an analysis using US large-cap stocks as an asset class – or even technology as a sector – they would be assigned the same level of risk. We know this is not an exact picture and relying on it could lead to unintended consequences. A bottom-up analysis of individual securities provides transparency into the various risks actually faced by Microsoft and Twitter.
Same asset class, different risk
Example for reference only. Source: BlackRock, Aladdin Portfolio Risk Tools. Data as of 09/30/20. See the important notes at the end for additional information on the S&P 500.
As the chart above shows, the annualized volatility of the S&P 500 over the past 10 years, which includes Microsoft and Twitter, is 15%. But if you look at the individual stocks, you’ll see that Microsoft’s risk is actually 20% and Twitter’s is more than double at 44%. This means that Microsoft and Twitter have the potential to work very differently within a portfolio – in fact, we might expect them to work differently – but asset class analysis alone would tell you that they should act the same way (15%), effectively ignoring this significant difference.
food for thought
Protein is an important part of our diet. But we don’t ask for “protein” when we want chicken because we could end up with tofu, which changes the whole meal. An asset allocation analysis is like asking for protein – why not just ask for chicken? Bottom-up analysis provides a more specific and accurate view of risk, helping to cook the meal customers really want.
Technology enables deeper conversations
Wealth management firms and advisors have traditionally used asset allocation because it’s simple and they haven’t had the wherewithal to analyze risk more deeply across their business. But the technology now exists to make these more meaningful conversations about risk possible. Seventy-five percent of advisors surveyed by BlackRock say discussing risk helps clients understand their value, suggesting clients want to talk more about risk.*
The graphs below show the dispersion of risk and reward for a group of 60/40 portfolios with a bottom-up view of risk. Over a 3-year period, this variation in risk can lead to very different return results, which advisors could not highlight with analyzes based on asset allocation alone.
Different risks, different return outcomes
Example for reference only. Source: BlackRock, Aladdin. Data as of 09/30/20.
Advisors who use sophisticated technology to understand the underlying risks in specific portfolios can provide more transparency about potential outcomes and demonstrate more expertise in client engagements to help build trust and deepen relationships.
Aladdin Wealth is that technology… and more
Expectations about how advisors manage portfolios have evolved. When advisors turn on their desktop, the information they need for deeper analysis is already there with Aladdin Wealth. They can now better understand the return and risk factors of their clients’ investments and do more to inform clients of the potential impacts on their portfolios. The portfolio and risk analytics technology available through Aladdin Wealth can help advisors reduce blind spots when serving their clients and supports the ongoing transformation of your wealth management business.
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* BlackRock “Tech in Business” Advisor Survey, 2020. A total of 510 US advisors with at least $25 million in assets under management participated in the survey.
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