The Power of Dynamic Asset Allocation

Diversification plays an important role in investing and the implementation of diversification within a portfolio can be a powerful tool that mitigates risk. However, diversification itself may not always be enough to achieve an investor’s goals and, in some instances, can even stand in the way. We believe a dynamic approach to portfolio construction that improves upon traditional asset allocation methodologies can offer better risk-adjusted returns.

A Traditional Approach to Asset Allocation

A common approach to asset allocation seeks to identify a set number of investable asset classes for inclusion in a portfolio. Once asset classes are selected, restrictions are then placed on each asset class, in essence, creating a minimum and maximum allowable weighting. Next, a portfolio manager will generate assumptions for risk, return, and correlations between each asset class and input these assumptions into an asset allocation tool that implements a mean-variance optimization process (MVO). These inputs can be derived from forward-looking models or historical risk, return, and correlation data, or a combination of the two. The MVO then derives asset mixes that produce the highest level of projected return for a given level of risk based on these inputs.

Dynamic Asset Allocation

The dynamic asset allocation approach seeks to improve upon the traditional approach in two distinct ways. The first recognizes that risk and return assumptions are constantly challenged by changes in market dynamics. As such, dynamic asset allocators do not view return, risk, and the relationship between asset classes as static assumptions. Secondly, as opposed to maintaining a minimum allocation weight to each sub-asset class for the sake of diversification, a dynamic allocation will effectively set minimum allocation ranges for sub-asset classes to zero. This allows an investment manager to avoid allocating to sub-asset classes that they believe may have unfavorable risk and return profiles, or said differently, sub-asset classes that the manager deems are, or will be, out of favor moving forward.

Naturally, this leads to a greater allocation, or overweighting, to the other sub-asset classes that the manager believes to be more in favor for the given market environment.

The goal of a dynamic asset allocation portfolio is to generate returns equal to or greater than those of the constrained portfolios produced by a traditional approach while assuming similar to less risk.

Power of dynamic asset allocation1

To pursue these returns, dynamic allocations deviate from the constrained portfolios generated through the traditional approach by either avoiding/underweighting sub-asset classes that are represented in constrained portfolios or by allocating to sub-asset classes that are not represented in the constrained portfolios.

Continue reading about the power of dynamic asset allocation, including analysis of risk/return impact on asset allocations using three hypothetical portfolios, a real-world example, and more in the full white paper PDF.

“Madison” and/or “Madison Investments” is the unifying tradename of Madison Investment Holdings, Inc., Madison Asset Management, LLC (“MAM”), and Madison Investment Advisors, LLC (“MIA”). MAM and MIA are registered as investment advisers with the U.S. Securities and Exchange Commission. Madison Funds are distributed by MFD Distributor, LLC. MFD Distributor, LLC is registered with the U.S. Securities and Exchange Commission as a broker-dealer and is a member firm of the Financial Industry Regulatory Authority. The home office for each firm listed above is 550 Science Drive, Madison, WI 53711. Madison’s toll-free number is 800-767-0300.

Any performance data shown represents past performance. Past performance is no guarantee of future results.

Non-deposit investment products are not federally insured, involve investment risk, may lose value and are not obligations of, or guaranteed by, any financial institution. Investment returns and principal value will fluctuate.

This website is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

Our expectation is that investors will participate in market appreciation during bull markets and be protected during bear markets compared with investors in portfolios holding more speculative and volatile securities. There is no assurance that these expectations will be realized.

Please consult with your financial advisor to determine your risk tolerance and investment objectives. While Madison constructs portfolios for various risk tolerances, its Asset Allocation Team does not determine individual client’s risk tolerance or investment objectives.

All investing involves risks including the possible loss of principal. There can be no assurance the asset allocation portfolios will achieve their investment objectives. The portfolios may invest in equities which are subject to market volatility. In addition to the general risk of investing, the portfolio is subject to additional risks including investing in bond and debt securities, which includes credit risk, prepayment risk and interest rate risk. When interest rates rise, bond prices generally fall. Securities rated below investment grade are more sensitive to economic, political and adverse development changes. International equities involve risks of economic and political instability, market liquidity, currency volatility and differences in accounting standards.

Each portfolio is subject to the risks and expenses of the underlying funds in direct proportion to the allocation of assets among the underlying funds.

The allocations described in this material are based on various indices and do not represent any Madison strategy or investment. They should not be considered indicative of Madison’s investment advisory skills.