When sitting down with an investment adviser to discuss your investment needs and goals, the first objective would be to ascertain your investment portfolio’s Strategic Asset Allocation (SAA).
Considering your investment horizon, discussing the balance between growth and preservation of capital, whether you need an income distribution from the portfolio, your tolerance and appetite for market volatility – these factors all play a significant part in the composition and management of your long-term investment portfolio.
However, your selected strategy is never set in stone as investor’s circumstances change over time – someone passes away, divorce, changing income needs, gifting capital to children, or if you are lucky, a Lotto win! But, within a strategy, a portfolio manager is actively managing the exposure to the different asset classes. The portfolio is rebalanced when the original allocations deviate significantly from the initial settings due to differing returns. This is called tactical or dynamic asset class management or allocation. A critical part of any investment strategy, active portfolio management is what you pay for.
Strategic asset allocation is compatible with a buy-and-hold strategy as opposed to Tactical Asset Allocation (TAA), which is more suited to an active trading approach. Strategic and tactical asset allocation styles are based on modern portfolio theory, which emphasizes diversification to reduce risk and improve long-term portfolio returns.
Tactical asset allocation is an active management portfolio strategy that shifts the percentage of assets held in various categories to take advantage of market pricing anomalies or strong market sectors. This allows portfolio managers to create extra value by taking advantage of certain situations in the marketplace. It is a moderately active strategy since portfolio managers return to the portfolio’s original strategic asset mix once reaching the desired short-term profits.
Unlike stock picking, tactical asset allocation involves judgments on entire markets or sectors. Consequently, some investors perceive TAA as supplemental to multi fund investing.
The benefit of selecting a specific strategy is that you can then plan your affairs accordingly. We all know that the past performances of an investment strategy or an asset class does not promise the same future returns, but it provides an indication of what can be expected going forward from a strategy or an asset class.
Strategic Asset Allocation Example:
Suppose 60-year-old Mr. Jones, who has a conservative approach to investing and is five years away from retirement, has a strategic asset allocation of 40% equities / 40% fixed income / 20% cash. Assume he has a $500,000 portfolio and rebalances his portfolio annually. The dollar amounts allocated to the various asset classes at the time of setting the target allocations would be equities $200,000, fixed income $200,000, and cash $100,000.
After a year of investing, suppose the equity component of the portfolio has generated total returns of 10% while fixed income has returned 5% and cash 2%. The portfolio composition is now equities $220,000, fixed income $210,000, and cash $102,000.
The portfolio value is now $532,000, which means the overall return on the portfolio over the past year was 6.4%. The portfolio composition is now equities 41.3%, fixed income 39.5%, and cash 19.2%.
Based on the original allocations, the portfolio value of $532,000 should be allocated as follows: equities $212,800, fixed income $212,800, and cash $106,400. The table below shows the adjustments that must be made to each asset class to get back to the original or strategic target allocations.
Thus, $7,200 from the equity component must be sold to bring the equity allocation back to 40%, with the proceeds used to buy $2,800 of fixed income, and the balance of $4,400 allocated to cash.
Note that while changes to target allocations can be carried out at any time, they are done relatively infrequently. In this case, Mr. Jones may change his allocation in five years, when he is on the verge of retirement, to 20% equities, 60% fixed income, and 20% cash to reduce the volatility of investment portfolio.
Russel Investments has done a sterling job putting together the performance table of the main asset classes available to New Zealand investors. They have done so by listing the 30-year returns and then combining them into three multi-asset portfolios to illustrate the comparative returns over the same period should you have been invested in a specific strategy. This is up to the end of December 2022.
From my perspective the key take aways from the Russel Risk vs Return 2023 Edition is the following:
- The years 2000 to 2002, 2008, 2018 and 2022 were the worst performing years for a multi-asset portfolio over the past 30 years.
- If you invested all your capital in either New Zealand or Global Equities, you would have outperformed a Multi-Asset Growth portfolio over the 30-year period. But you would have experienced higher volatility in your investment portfolio when you compare the average risks of the two asset classes vs that of a managed Growth portfolio.
- As I write this article, Cash is King, currently delivering close to 6% per annum if invested in a 12-month term deposit, but it is never a long-term investment option as shown in the table. The average return of cash is just 3.8% per annum, and fully taxable, barely outperforming the New Zealand inflation rate.
- The performance of the Conservative strategy, delivering an average return of 7% is amazing and delivered with a 5.6% risk premium. I think the chance of that happening again in the future is very slim. Remember, interest rates have dropped from more than 20% per annum since the late 1980’s and what are the chances of interest rates jumping that high again?
In summary…
My view is that long-term retirement capital should be invested in multi-manager portfolio (my article on multi-manager portfolios). I suggest that after in-depth discussions with your adviser and based on his/her recommendation, you select a specific investment strategy that can deliver results. Ideally placing your funds with an investment manager who does active tactical asset allocation using different asset classes and different specialist fund managers.
Then, stick to your long-term investment strategy, only deviating from it when your circumstances, goals and objectives have changed.
Sources for the asset classes and sample diversified portfolios are as follows:
NZ Shares: Russell NZ Domestic Gross Index (Replaced with S&P NZX 50 Gross including imputation credits from June 2016).
NZ Cash: S&P/NZX 90-day Bank Bill Index. NZ Bonds: S&P/NZX NZ Government Bond Index. Global Bonds: Bloomberg Global Aggregate Total Return Index Hedged NZD. Global Share: MSCI World NZ$ Hedged.
The diversified portfolios are hypothetical only and are calculated by a weighted average of the asset class index returns shown using sample asset allocations. Sample diversified portfolios are rebalanced monthly. Average return is measured by the arithmetic average percentage per annum. These returns are shown on a gross basis. The information contained in this publication was prepared by Russell Investment Group Limited on the basis of information available at the time of preparation. It has been compiled from sources considered to be reliable but is not guaranteed. This publication provides general information only and should not be relied upon inmaking an investment decision. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation and needs. All investments are subject to risks. Past performance is not a reliable indicator of future performance.
