Asset allocation sets forth a framework for investor’s portfolio and establishes a plan for identifying lucrative investment avenues. Proper asset allocation shades investors’ investments against market volatility and at the same time ensure that the individuals’ investment goals are achieved. The interconnectedness of financial markets means that when one market is performing on a high note the other market would be undergoing a rough patch. Financial managers exploit this situation to create the perfect investment portfolio where the overall wealth of the individual increases regardless of the condition of the market.
In this report we seek answer to the following questions regarding asset allocation:
- What are the salient features of asset allocation?
- Why is asset allocation so important today?
- What is the connection between asset allocation and diversification?
- How big financial firms are executing asset allocation strategies? and
- What are the future trends and strategies relating to asset allocation?
- 1 Introduction
- 2 Why Asset Allocation Is So Important
- 3 Asset Allocation Strategy: Industry Insight
- 3.1 1. J P Morgan Asset Allocation Model
- 3.2 2. California Public Employees’ Retirement System (CalPERS) Model
- 3.3 3. Chase Investment Service Corp. Asset Allocation Model
- 3.4 4. Citigroup Asset Allocation Model
- 3.5 5. Barclays Bank Asset Allocation Model
- 4 Future Trends in Asset Allocation
- 5 References
“Put not your trust in money, but put your money in trust.”
― Oliver Wendell Holmes
Asset allocation refers to dividing an investment portfolio in a way that brings maximum returns for individual investors. Effective asset allocation maximizes the return potential of the investment portfolio while reducing the risk of loss of the investment amount. The process of determining effective portfolio mix depends on risk tolerance and the time horizon of the investor.
The foundation of asset allocation strategy rests on two key assumptions, which are perfectly valid in the real world. The first is the interconnectedness of financial instruments. The different types of financial instruments operate like a pendulum in the financial market. Similar to the extreme ends of the pendulum some asset classes experience extreme volatility while others that lie in the middle do not experience much change. A well-constructed portfolio includes a diverse range of asset classes – with high and low volatility – that brings maximum benefits to the investors.
The second important assumption of asset allocation is investing for the sake of investment and not speculation. In devising an asset allocation strategy, a portfolio manager has to keep the long-term perspective in mind. The goal of asset allocation strategy is to obtain the maximum benefit over a long period rather than short-term gain. As Warren Buffet famously stated price is what you pay, the value is what you got. The asset manager may add a poor performing financial instrument in the portfolio if it is expected to add to the portfolio wealth in the five to ten years duration.
Why Asset Allocation Is So Important
Effective asset allocation plays a pivotal role in protecting individual investment against the volatility of the financial market. Including different asset classes in the investment portfolio protects the investment against significant losses. The returns of the asset classes have never shown similar trend during a particular period of time. Market conditions that cause one asset class to trend upwards also cause the other asset class to move in a downward direction.
Due to this during a particular business cycle, one asset class would be providing tremendous returns while another asset class would give average or negative returns. By investing in more than one asset classes, the risk of loss would be kept to a minimum. At the same time, it will also ensure that net investment returns remain positive over a particular long-term duration. If returns of one asset class fall, the gains in other asset class would counteract the position. This practice of spreading investment across different asset class to reduce risk is known as diversification.
The Connection between Asset Allocation and Diversification
Diversification as an asset allocation strategy is best explained by the age old adage that, “Do not put all your eggs in one basket.” Diversification plays an important role in the successful allocation of the financial resources. It limits the losses without sacrificing potential gain of the investment portfolio by much.
Both big Investor firms and individual investors use diversification strategy to achieve the goal of the investment portfolio. The strategy refers to spreading the investment portfolio among various types of financial instruments in a way that if one asset class incurs a loss, the other investment class would counter the effect of loss. This would result in a net overall gain of the investment portfolio.
Asset allocation without diversification will not allow you to achieve risk / return balance of the investment portfolio. For instance, entirely in stock or precious metal such as gold might not be a reasonable asset allocation strategy under any circumstances. The first financial instrument experiences extreme market price volatility with prospects of high returns and losses. And although the probability of loss is low on the second investment asset class; the return potential is also very low. A diversified portfolio ensures that the net portfolio returns are positive.
Ideal diversification strategy depends on how the investment amount is spread over a different class of investment instrument. A study by Dalbar Associates found that stock investors averaged a 4.3% annual return over a period of two decades while average bond investor averaged 1% annual returns during the same period. In contrast, the S&P stock index and BC Agg Bond Index rose by 8.2% and 6.3% respectively. The two indexes contain a basket of stocks and bonds with different risk and return profile. This only shows that average investors missed out about half the positive market performance just because they were not able to diversify their investment portfolio. If they had practiced diversification strategy in allocating the assets, their return would have been similar to that of the respective indexes.
Asset Allocation Strategy: Industry Insight
1. J P Morgan Asset Allocation Model
J.P. Morgan Asset Management is a division of JP Morgan Chase & Co. and its affiliates worldwide. Asset Management Solutions – Global Multi-Asset Group (AMS-GMAG) is a dedicated asset allocation team within J.P. Morgan that is responsible for preparing model asset allocation portfolio for institutions, individuals, and financial intermediaries.
The asset allocation strategy of the company looks for balancing returns with risk. It tends to avoid unintentional risk exposures through a well-diversified portfolio. The assets are allocated across various asset classes and security with different risk-return profiles.
The company utilizes broad research inputs to formulate active asset allocation strategies. It relies on three distinct sources of research via Quantitative Research and Modeling, Macro Economic Research, and High Conviction Opportunistic Ideas from Strategic Managers. The key objectives of J.P. Morgan’s asset allocation strategy include:
- Opportunistic alpha generation
- Liability matching
- Total return
Opportunistic Alpha Generation
Opportunistic alpha generation refers to seeking a high return on investment as compared to the risk-adjusted expected return. Alpha measures the risk-adjusted performance of an asset. The return of a particular asset may be high but it may not compensate for the risk taken. The risk here refers to the volatility of the asset. An alpha of zero or above means the return on investment compensates the risk. Alpha of less than zero indicates that the returns are not adequate to compensate the risk. J.P. Morgan has flexible alpha and risk goals that provide maximum benefit to the investors. It strives to seek opportunistic alpha generation through allocating its assets in fixed income, global equity, and real assets.
J.P. Morgan aims to diversify the stock portfolio by geography, liquidity, capital structure and portfolio style. The company uses active asset allocation by sourcing alpha through active asset allocation strategy. It evaluates both traditional and alternate asset classes before including them in the investor’s portfolio.
J.P. Morgan’s second asset allocation objective is liability matching. The company focuses on liability centered asset allocation to reduce risk without concentrating capital in low yield fixed income investment instrument. Through this active asset allocation strategy, the company strives to reduce surplus volatility as funding gap heals. The company blends liability hedging, asset de-risking, and asset diversification in allocating resources to various asset classes.
Finally, the third objective of J.P. Morgan’s asset allocation strategy is maximizing portfolio’s total return. The company applies outcome driven asset allocation strategy by investing in traditional and alternative asset classes. The company makes use of broad discretion global ideas in making asset allocation decisions. J.P. Morgan believes in sample strategic outcomes with 7-8% total returns and 5% real returns. The aim is to outperform the clients internally managed a portfolio with the similar risk-return profile. The company also examines the alternate sources of return of the investment class such as from real estates, private equity, and hedge funds.
J.P. Morgan’s asset allocation chart above shows asset class returns over a period of 10 years. The asset allocation portfolio includes diversified asset classes (depicted in the graph above) that reduce volatility and enhance returns.
The company utilizes in-depth research, capital market knowledge, and active asset allocation strategy to build a diversified portfolio that offers attractive opportunities suitable to clients risk appetite and return requirements. J.P. Morgan’s approach dumps traditional wisdom that returns are normally distributed on a bell curve that is independent of each other.
Instead, the company believes in “flat tail events” – such as the Bursting of Dot Com Bubble and 2008 subprime mortgage disaster – that affects the trajectory of returns rather than standard deviation measures. It assumes a non-normal distribution of returns and incorporates a downside risk defined as an average real loss in the 5% worst cases in a simulated return distribution.
2. California Public Employees’ Retirement System (CalPERS) Model
California Public Employees’ Retirement System (CalPERS) is a state agency in California that manages pensions and health benefits of more than 1.6 million public staff, retirees, and their families. It manages the largest public pension fund in the U.S. with estimated assets worth more than $300.3 billion. In 2013, the company paid over $7.5 billion in health benefits and $12.7 billion in retirement benefits.
CalPERS derives most of its income from investments gains. The agency is a recognized leader in the investment industry and is one of America’s most powerful shareholders. The Stocks placed on its “Focus List” generally perform better than other stocks. The criteria for placing stocks on the Focus list have changed over time, but generally, it includes stocks of companies with concern about financial underperformance and corporate governance practices.
The CalPERS Investment Committee sets forth asset allocation objectives and purpose with respect to all of its investment programs. CalPER’s investment policy is contained in Investment Beliefs Policy and Total Fund Statement of Investment Policy, while CalPER’s asset allocation strategy is included in Statement of Investments Policy. The key objectives of CalPER’s asset allocation strategy include:
- An asset allocation mix with targets set by periodic asset liability management (“ALM”) review;
- Maintain suitable diversification to preserve capital and avoid large losses;
- Maintain enough liquidity to meet cash demands;
- Achieve highest possible rate of total return with adequate levels of risk and liquidity;
- Ensure that rebalancing of asset portfolio
- Generate positive returns Using active asset allocation decisions subject to policy changes and risk limits
Strategic Asset Allocation Approaches
Most asset allocation agencies generally utilize passive investment strategy in that they do not take an active part in improving governance or financial performance of the underlying stocks’ company. CalPERS, on the other hand, actively cooperate with the invested stock’s companies to improve their corporate governance and thereby financial performance. The company establishes asset class policy targets that meet its asset allocation objectives outlined above. It strives to achieve positive asset allocation returns over a rolling five years period.
The above table shows the asset allocation targets of the company that were approved by the Committee and Board in February 2014 and implemented in July 2014. The table shows that CalPER set a policy target of allocating 59% of the fund on growth equities, 11% in real estate, and 3% on infrastructure development. Around 8% of the fund would be reserved in liquidity and inflation assets.
The company makes asset allocation decisions after considering asset class volatilities, expected returns and their correlations. Other factors that are considered in making asset allocation strategy include:
- Projected funds
- Projected costs of investment
- Probability of deterioration of fund, and
- Probability of unexpectedly high cost
J.P. Morgan allocates funds using the CalPERS Risk Management System with a target forecast annual tracking error of 0.75%. This means that over any 1 year period there would be less than 5% probability that the asset allocation would result in negative returns of 1.2%.
3. Chase Investment Service Corp. Asset Allocation Model
Chase Investment Services Corporation (CISC), an affiliate of J.P. Morgan Chase & Co., is an investment firm that offers securities and investment advisory services to the clients. The company offers investment advisory, brokerage services, and portfolio management help. CISC provides clients with professionally managed accounts, mutual funds, exchange-traded funds, money market funds, annuities, personally managed accounts, education funding and retirement funding.
Chase asset allocation strategy is carefully constructed after evaluating the investment objective of the clients. The objective of asset allocation strategy is to earn maximum possible returns from the portfolio. It focuses on creating a broadly diversified portfolio with funds allocated across multiple equities and fixed income assets. Chase portfolio models are constructed after a thorough analysis of risk and return potential of each asset class. The funds are then allocated based on risk tolerance and investment time horizon of the client.
Chase asset allocation model comprises of U.S. equity, non-US equity, fixed income, and cash. The company allocates its funds over the different asset classes to optimize the risk and reward balance. It uses seven different approaches to allocating the fund. The type of asset allocation strategy chosen by the depend on the risk and return requirement of the clients.
Conservative and Balanced model invests the majority of funds in fixed income and cash. Growth income model invests around 50% of the fund in equities and 50% in fixed income & cash. Finally, the aggressive model allocates the majority of funds in the equity market.
A particular strategic portfolio model is chosen after a face-to-face meeting between the client and the Chase Investment Services financial advisor. The financial advisor works with the client to identify short term and long term financial needs, risk tolerance and expected returns. The client would then have to select from 35 distinct investment portfolios that fulfill unique financial goals.
4. Citigroup Asset Allocation Model
Citigroup Asset Management Company is a division of Legg Mason Inc. that manages client-focused fixed income, equity funds, and balanced portfolios. The firm invests in fixed income and equity market across the globe. Clients of the firm include individuals, corporations, central banks and supranational organizations.
The company follows a unique wealth management approach in allocating resources to various asset classes. It takes into account concerns and goals, comfort level for risk, financial status, and investment time horizon. The wealth management asset allocation strategy consists of 8 steps that are listed below:
- Identify Financial Needs
- Understand Risk Tolerance and Profile
- Review Portfolio Models (Detailed Below)
- Conduct Objective Research
- Select Products
- Create and Evaluate the Portfolio
- Monitor Portfolio Performance
- Rebalance the Portfolio (if required)
The company divides the portfolio fund among major asset classes such as bonds, equities, cash or cash equivalents, and alternative investments. Each asset class is evaluated to find out the risk-return characteristics. Afterward, funds are allocated to the asset classes that meets the requirements of the client.
Diversification of portfolio lowers the overall risk exposure while fulfilling portfolio return requirements. The company utilizes five asset allocation models to fulfill the requirements of various clients. Level I & II are conservative asset allocation models with the majority of investment in fixed income asset classes. These models entail low growth potential, least possible risk, short-term investment horizon and minimum price volatility.
Level III is a balanced asset allocation strategy with about an equal amount of fund allocated to fixed income assets and equities. This asset allocation model medium growth potential, moderate risk, medium term investment horizon, and moderate price volatility.
Finally, Level IV and V are aggressive asset allocation strategy where the majority of the fund is allocated to equity asset classes. The asset allocation model involves high growth potential, very high risk, long-term investment horizon, and significant price volatility.
5. Barclays Bank Asset Allocation Model
Barclays is a multinational bank and financial service firm with headquarters in London. The financial service firm provides retail, wholesale, and investment banking services. The bank also provides wealth management, mortgage lending, and credit cards services to the clients. It has branches in over 50 countries and has a customer base of about 50 million. In terms of banking assets, it is regarded as the seventh largest bank in the world.
The company uses Black-Litterman model to estimate future returns of asset investments. Black Litterman model was developed around 20 ago by Robert Litterman and Fisher Black. According to this model the expected relative returns on different investments tend to move toward the equilibrium values. The equilibrium value of any asset is the anticipated level of return given how the return relates to other asset classes and how risk is that investment. This value is used to determine whether the investors would hold the total market value of the asset.
For example, the expected return on government bonds does not have to be high relative to returns on other investment since they are not that risky. Also, the returns on government bonds tend to be negatively correlated with returns on other risky assets such as stocks. This will induce investors to hold the government bonds. On the other hand, the expected return on equities needs to be high as the risks are also high.
Barclays bank uses three basic principles in its asset allocation process, these include:
- Asset Class Diversification
- Investment Availability (Investment in broad categories of assets which are readily available to all investors rather than specific types of products)
- Making Asset Allocation Decision based on Macroeconomic and Market Views
Barclays bank uses three basic principles in its asset allocation strategy. Six of the asset classes are traditional viz cash and short maturity bonds, government bonds, investment grade bonds, high yield and emerging market credit, developed and emerging market equities. While three of the asset classes are nontraditional and include commodities, real estate, and alternative trading strategies.
The company uses Black Litterman model to develop optimal asset allocation strategy tailored to the needs of the clients. The company includes asset class in its portfolio if it provides good risk-adjusted returns; tends to perform well during economic downturns; accessible by affluent investors; adding the asset class in the portfolio does not increase complexity in managing the portfolio.
Future Trends in Asset Allocation
Looking forward, companies would most probably continue the current trend in allocating resources to various asset classes. However, with investors demanding for more and more from their portfolio investment, the absolute scale of asset allocation would increase considerably in the next few years.
The changing trends in asset allocation would also be fueled by changing pattern of global growth in the future. Emerging market funds especially those related to China and India would gain prominence. As a result of which global portfolio management industry would continue its march in an upward direction.
An important trend in asset allocation would be the rapid growth of specialized funds that would replace investment in cash and other less liquid asset classes. Specialized funds include index annuities, precious metals, and infrastructure and commodity funds. These funds have appreciated from $2 trillion dollars in 2003 to about $6 trillion in 2012. The portfolio management firms would continue to allocate funds to these specialized asset classes.
Emerging market funds is another promising asset class that would be in demand in the future. Since 2008, investment in these funds has grown by about 40% per annum – far outpacing growth in the global mutual fund industry. Finally, there is also expected to be an upsurge in US mutual loan funds. Investment in these funds peaked in 2013 amounting to $63 billion and averaged $15 billion in the past three years.
- Joel Chernoff. (2009). “JPMorgan dumps tradition: Firm creates a new asset allocation tool that embraces ‘fat-tail’ events”, Retrieved on January 27, 2015, from http://math.colgate.edu/math102/Common/Readings/JPMorgan_dumps_tradition.pdf
- “Facts at a Glance” (PDF). CALPERS. July 2013. Retrieved July 8, 2013.
- CalPERS at a glance: pension program. December 2014. Retrieved December 09, 2014.
- Facts at a glance: CalPERS HEALTH PROGRAM. December 2014. Retrieved December 09, 2014.
- Boston Consulting Group (2013), “Global Asset Management 2013: Capitalizing on the Recovery”.
 Joel Chernoff. (2009). “JPMorgan dumps tradition;
Firm creates a new asset allocation tool that embraces ‘fat-tail’ events”, Retrieved on January 27, 2015, from http://math.colgate.edu/math102/Common/Readings/JPMorgan_dumps_tradition.pdf
 “Facts at a Glance” (PDF). CALPERS. July 2013. Retrieved July 8, 2013.
 CalPERS. CalPERS at a glance: pension program. December 2014. Retrieved December 09, 2014.
 Facts at a glance: CalPERS HEALTH PROGRAM. December 2014. Retrieved December 09, 2014.
 Boston Consulting Group (2013), “Global Asset Management 2013: Capitalizing on the Recovery”.