Switch to dynamic asset allocation

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Long-term investors will need to adopt next-generation strategic asset allocation practices to successfully play their part in a rapidly changing world. Truths, practices, and principles traditionally accepted by long-term investors face diminished importance and potential obsolescence. We’ll examine key topics and expected changes in how long-term investors will make their investment decisions in a series of articles on multi-horizon strategic asset allocation applications. In this article, we examine the advantages of dynamic rebalancing over the constant mix (fixed mix) approach in strategic asset allocation.

Multi-horizon analysis summary

In our previous article, we introduced multi-horizon analysis and argued that few long-term investors take a purely buy-and-hold approach to their investments. Fixed-mix has been introduced as a practical alternative, in which an investor periodically rebalances original allocations. The impact of such an action modifies the risk/return ratio of the investment and presents a different efficient frontier for the investor.

A single set of weightings for the entire investment horizon ignores the flexibility that many investors have to change their asset allocation to exploit investment opportunities and manage risk.

Why think about dynamic asset allocation?

Few investors expect the return and risk of the asset class to remain static throughout the investment horizon. Allowing weights to change dynamically over time to take advantage of market opportunities is a natural extension of the fixed composition approach. We call this a dynamic rebalancing strategy or dynamic asset allocation.

To illustrate, we use the following capital market assumptions (CMA) input data. The risk (volatility) is estimated from historical return data.

Table 1: Expected returns and volatility of different asset classes

Asset classes

Expected return (annualized)

Volatility

5 years

10 years

20 years

US stocks

6.4%

6.6%

6.9%

15.5%

European Equities

7.5%

7.5%

7.5%

19.3%

Emerging Equities

6.6%

7.0%

7.6%

20.1%

Government bonds

0.8%

1.3%

2.0%

3.7%

Global Bonds

1.2%

2.0%

2.8%

3.0%

Credit 3-10 years

0.2%

1.7%

3.4%

4.5%

Credit +10 years

-0.8%

0.7%

3.2%

8.9%

Long government

-0.1%

0.9%

2.0%

11.3%

Source: FactSet

When using a traditional single-period asset allocation approach, an investor with a 20-year investment horizon is forced to select a single set of return forecasts when constructing the optimal allocation. The appropriate choice is not obvious as several options are available:

  • Use the return forecast that corresponds to the investment horizon (20 years). In this case, the portfolio is likely to overexpose the investor to the low yields of fixed income securities during the first five years.
  • Use the return forecast in the immediate period (five years). One could argue that since you’re only setting your portfolio allocations for the immediate future, only short-term forecasts matter. Also, shorter term forecasts are likely to be associated with less error. Taking this approach effectively ignores the long term, and successive short-term allocations could lead to a long-term average allocation quite different from that constructed with the long-term inputs.
  • Use an average of the yield forecasts. The use of averages ignores opportunities to be exploited in the short and long term. This is analogous to duration-only monitoring, which omits important nuances in a barbell fixed income strategy.

Dynamic asset allocation does not impose any choice and makes it possible to use all the information in table 1. At each period, the portfolio is optimized according to all the information provided; weightings are allowed to change dynamically from period to period to exploit investment opportunities. Focusing on the 3-10 Year Credit asset class, we can see that it should experience the most significant improvement in returns over the investment horizon. Intuitively, we expect to see a corresponding increase in allocation throughout the investment horizon.

What does dynamic asset allocation look like?

Below is the ex-ante evolution of the portfolio weights for a dynamically rebalanced portfolio versus a fixed composition portfolio with the same data from Table 1.

dynamic-allocation-targeting-six-percent-annualized-return

Why use Dynamic Asset Allocation?

Dynamic allocation provides a much richer result and generates analysis, observations and healthy discussions between investors and investment managers. Improving communication and understanding of investment strategy and likely outcomes helps promote long-term investment behaviors among managers and investors.

Here are examples of areas enhanced by dynamic asset allocation:

  • Validation of expectations. The increase in the allocation to Credit3-10 years from year 10 corresponds to our observation of the increase in the expected return of the asset class.
  • Communication tool. It is much easier to explain to an investor why he should care about the LongGovt and Credit3-10yr asset classes even if the allocation is initially low if he can see the future importance of the asset classes.
  • Modeling challenge/input assumptions. The detail of the output can reveal gaps in input modeling and assumptions that would otherwise go unnoticed. For example, LongGovt and Credit3-10year trade in the wallet over time. Is it reasonable and expected?
  • Ability to layer implementation considerations. A rotation constraint of 40% introduces some “smoothing” of allocation changes. For example, aggregate bonds take three years to disappear from the portfolio; the turnover budget was better spent elsewhere in the early years. Similarly, it takes several years for the allocation to the 3-10 year credit to gain full momentum.
  • Realistic reflection of the characteristics of the rise and blocking of private investments. Allocation to private asset classes may be allowed to increase gradually during ramp-up. Then they can be fixed for the blocking period and allowed to change dynamically after the blocking period ends.
  • More sophisticated rebalancing decision rules (business rules). Business rules are triggered by reaching certain thresholds such as Constant proportion portfolio insurance (CPPI) or minimizing cash contributions to the portfolio.

Not surprisingly, allowing portfolio weightings to change over time results in a greater range of risk/return opportunities. Critically, when the range coincides with other strategies such as buy and hold and constant combining, the efficient frontier of the dynamic strategy dominates the other strategies.

efficient-frontiers-20-year-investment-horizon

And after?

Enabling dynamic rebalancing is a powerful part of the next generation of strategic asset allocation tools. Giving an idea of ​​how weightings are likely to change over time helps to better ask questions and better understand the characteristics of a particular investment strategy.

Our next article will explore how multi-horizon analysis can help provide long-term investors with more appropriate analysis and approach to managing risk.

Todor Bilarev, PhD, Senior Quantitative Researcher, Analytics and Trading Solutions, contributed to this article.

Disclaimer: This blog post is for informational purposes only. The information in this blog post does not constitute legal, tax or investment advice. FactSet does not endorse or recommend any investment and assumes no responsibility for any consequences related directly or indirectly to any action or inaction taken based on the information in this article.

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