Christian Nolting, regional head of portfolio management and lead strategist for Asia-Pacific at Deutsche Bank Private Wealth Management shares his views on the importance of Asset Allocation and explains why this approach could be beneficial for investors in the long term.

The Asset Allocation approach has been found to be one of the most effective in managing clients' wealth over the long term. Why do think this is the case?

The Asset Allocation (AA) approach has been developed over the years based on various academic as well as practical studies. The essence of the approach is reflected in the words of Nobel laureate Harry Markowitz: "A good balanced portfolio is more than a list of good stocks or bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies." This approach allows incorporation of tools of Modern Portfolio Theory (MPT) which could be seen as the philosophical opposite of traditional stock picking. MPT is the creation of economists, who understand the market as a whole, rather than business analysts, who look for what makes each investment vehicle unique to achieve satisfactory performance. Overall client portfolios through this MPT approach can be analyzed and optimized in line with the client's risk taking capability.

Most private banks would see value in the AA approach for their private client portfolios. Theoretically, an appropriate distribution of wealth among different asset classes, with an individual strategy geared to the risk-return profile of the client being complemented periodically by dynamic and tactical decisions, is key for a sustainable and satisfying portfolio return.

What is the difference between Strategic Asset Allocation vs. Tactical Asset Allocation?

While implementing AA approach, clients' goals, liquidity needs, risk-return expectations are incorporated to define an investment goal. A combination of traditional asset classes like equity, bonds and money markets with alternative asset classes like commodities - to give an example - is suggested. Strategic Asset Allocation (SAA) is the long term combination of various asset classes that matches the client's risk profile and long term target. The primary factors driving SAA would be the long term return drivers for each asset class and the covariance matrix (correlation and volatility).

Tactical Asset Allocation (TAA), however, is more dynamic in that it takes into account short-medium term prospects for financial markets. The key factors driving TAA are for example the economic/ business cycle, market implied expectations, technical factors and sentiments. Tactical changes allow the client to be more dynamic especially in extreme times as seen in 2008 rather than having a 'buy and hold' strategy. In various phases of business or economic cycle the attractiveness of various asset classes varies and that is one of the key determinants for tactical calls. As an over-simplified illustration, bonds would be attractive in a typical reflationary environment while stocks would be attractive in economic recovery phase. Academic studies support the view that AA has the greatest impact on returns rather than security selection or market timing.

What would adopting the Asset Allocation approach benefit high net worth individuals - given that the investment universe of these investors would have Equities, Bonds, Liquidity and Alternative Investments as main asset classes?

First, not only do these asset classes vary in their risk-return dynamics but also typically with respect to correlation amongst them. At a sub asset class level, there are numerous options and they too vary from a risk (volatility) and return perspective. In a well diversified portfolio, it is possible to reduce risk while maintaining same level of returns by varying the proportion and number of low correlated asset classes accordingly. Simple example: An equal weighted portfolio consists of asset A and B having volatility/risk of 20% and 15% respectively with the correlation between them at 0.2. The resultant portfolio would show a lower volatility/risk of 13.65%, compared to a portfolio consisting 100% of either of the assets.

Second, AA in normal times benefits as no asset class performs all the time. Also a diversified portfolio has been found to be relatively safer from an event risk perspective.
Third, AA reduces the dependency on sheer market timing. A sound investment approach for clients is to set an investment strategy and follow it, albeit with tactical changes. However, radical changes in strategy regarding the SAA should not take place unless the clients risk profile has altered drastically. There is a value in following the AA approach as timing is an overrated factor of success. Market timing is a risky and difficult business from a pure statistical stand-point. Additionally, investments made with a shorter time frame are by definition riskier.

If we look at S&P 500 over a five-year investment period until 28 February 2009, we find that there is a significant difference in performance if the best performance days were missed. An S&P 500 investment over the last 5 years generated a net yield on average -8.50% per annum. However, missing the best 10 days of investment, a net yield of only -19.40% per annum was achieved.

2008 was a challenging year - with typical 'normal distribution' taking a back-seat and under-estimated fat tails became the norm. What is the role of Asset Allocation in the post crisis era?

During challenging market conditions, fat tails are considered undesirable because of the additional risk they imply. When data naturally arises from fat tail distribution, the normal distribution model of risk would severely understate true risk. Many, notably such as Nassim Taleb of 'Black Swan' fame, have noted this shortcoming of the normal distribution model and have proposed that fat tail distributions such as the stable distribution govern asset returns frequently found in finance. Theories such as Black Swan gained immense popularity as such rare events became common in 2008 - Bear Stearns collapse, Fannie Mae and Freddie Mac under conservator ship, Lehman Brothers bankruptcy, unprecedented government action globally - just to name a few.

Additionally, correlation between asset classes rose significantly in 2008 with only government bonds providing some diversification benefits. High level of leverage, illiquidity, operational and counter-party risk coupled with lack of transparency lead to elevated correlation especially for Alternative Investment asset class with equity market melt-down.

However, as highlighted previously, 2008 was anything but a normal period and there were structural changes taking place in the financial industry. 2008 crisis was a combination of a globally synchronised recession and financial crisis, thus making it an extremely volatile and chaotic period of reference.

If 5-year rolling correlation of each category to S&P500 is studied using rolling 12-month returns, the results are quite interesting. The correlation between asset classes has shot up dramatically over the last 9 years. The persistent low returns of this decade had caused some investors to use additional leverage to boost returns in these asset classes. The theory was that the risks associated with the leverage were immaterial, when compared to the significant risk-reduction benefits of investing in "uncorrelated" assets. While that theory was true nine years ago, closer study shows that 2000's non-correlated asset classes are now often highly correlated to the S&P 500, and their diversification benefits now seem to be greatly reduced.

What would be the conclusion?

The above trends further emphasise the need for more decisive and dynamic AA calls and do not build a case for a stable 'buy and hold' AA. This should be combined with various sub asset class tactical focus to gain more granularity. The target is to achieve the highest inflation adjusted return per unit of risk. Potentially, the AA approach has been found to be one of the most effective approaches in managing clients' wealth over the long term.