Asset allocation is one of portfolio management’s primary concerns. Asset allocation answers several questions. What risk-return trade-off are we comfortable with? In other words what amount of risk are we prepared to take to make a certain level of active return? At every level of active return there is an equivalent amount of risk. Many portfolio managers are judged merely on the return they have achieved without subsequent analysis of the risk they took to produce that return. This is the reason why we have seen the advent of new rogue traders like Kweku Odoboli. These traders want to make positions that give a certain amount of return so as to meet their stringent benchmarks wealth advisor.
Asset allocation can be done using either alpha or beta drivers. The alpha drivers measure the manager’s skill to generate the so-called active return. Active return is the difference between the benchmark and the actual return. Alpha is more aggressive and aims to achieve returns in excess of the stated benchmarks. Alpha drivers are normally classified as Tactical Asset Allocation (TAA). TAA facilitates an investor’s long-term funding goals by seeking extra return. It focuses of arbitrage in the sense that it takes advantage of unbalanced market fundamentals. TAA requires more frequent trading than does Strategic Asset Allocation (SAA) to produce the extra returns.
Beta drivers are the more traditional investment techniques that aim to meet the benchmarks. It involves the systematic capture of existing risk premiums. Beta drivers are used in constructing SAA. This type of allocation crystallizes an institutional investor’s investment policy. This process singles out strategic benchmarks tied to broad asset classes that establish the policy/ beta/ market risk. This type of allocation is not designed to beat the market and must meet the long-term funding goals of the organizations like defined benefit pension schemes.
Broad Classes of Alpha Drivers
1. Long or short investing
2. Absolute return strategies (hedge funds)
3. Market segmentation
4. Concentrated portfolios
5. Non-linear return processes (option-like payoff)
6. Alternative cheap beta (anything outside the normal stock/bond portfolio)
Typical Asset Allocation for an Institutional Portfolio
Fixed Income 30%
Real Estate 15%
Inflation Protection 15%
Breaking down the equity portion
Strategic allocation to equity could be broken down into the following sub-classes:
Beta drivers – 60%
• Passive equity
• Enhanced index equity
Alpha drivers – 40%
• Private equity
• Distressed debt
Convertible bonds have a hybrid structure which is a mixture of equity and fixed income securities thus may be included in either the equity or fixed income bucket.