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.
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.