ASSET ALLOCATION MODELLING

Asset Allocation Modelling
Anecdotal and academic evidence all points towards the fact that, for a given risk budget, asset allocation is the most important driver of return. There are two aspects to this: the strategic asset allocation decision and the tactical asset allocation shifts.

Strategic Asset Allocation
The basis for establishing a strategic asset allocation should be modelling the long term expected return characteristics of each asset class. Whilst historic returns can be helpful, of greater importance is the expected path of economic activity and global realpolitik. Big picture trends should be considered such as the impact of ageing populations; emergence of BRIC middle class; rising demand for commodities; environmental factors; etc.

Once a strategic asset allocation is agreed, it should be reviewed annually but always with a long term horizon.

Tactical Asset Allocation
If strategic asset allocation is peering into the next decade, tactical asset allocation can be characterised as reacting to financial market cycles by taking temporary overweight and underweight positions in various asset classes, regions and markets. Many investors find it difficult to differentiate between tactical and strategic decisions, leading to the classic investor mistake of selling at the bottom and buying at the top.

To provide a barometer on tactical asset allocation trends, we undertake a quarterly market sentiment survey. Around 50 private client discretionary managers provide views on the prospects for various asset classes for the following 12 months. These views are analysed and trends identified. The survey is of particular value in spotting evidence of herd mentality driven asset bubbles.