In my travels as one of BetaShares’ Directors of Distribution, I get to observe first-hand how some forward thinking advisers are approaching portfolio management. One area I am seeing a lot more of recently is advisers using asset allocation as a key component of an active portfolio management strategy. In a series of BetaShares Academy posts that I will write over the coming weeks, I’ll look in more detail at asset allocation and how it can be used to more actively manage portfolios. Advisers may find this type of approach useful as a way to add value to their client value proposition, whereas end-investors can equally use such an approach in the way they approach their investments.
Active Portfolio Management
When most investors think of “active portfolio management”, they think of the concept of picking shares that they believe will outperform the return level of the general market. With such a practice, by picking correctly an investor will generate excess returns, known as “alpha”, over and above the market return, thus generating a better investment outcome than available from the market itself.
Stock picking takes advantage of inefficiencies within an asset class (such as Australian Shares) and focuses on increasing exposure to individual companies that an investor believes may be undervalued, and decreasing exposure to individual companies that an investor believes may be overvalued.
Active stock picking is undoubtedly a potential way to generate alpha from Australian shares, but research indicates it is in fact only a relatively small part of the overall value-add that an investor can generate.
What is Asset Allocation? – Widening the Opportunity Set
Asset Allocation is possibly the largest piece of the active management pie, and arguably offers the largest means of generating “alpha”.
Asset Allocation is the practice of investing not just in one asset class (eg. Australian shares), but in several such as cash, international shares, bonds, currencies, commodities and alternative assets such as infrastructure and hedge funds.
Asset Allocation enables active management for “alpha” not just by trading WITHIN an asset class like Australian shares, but also by trading BETWEEN asset classes. It provides a dual source of alpha that is complementary to, but even more important than, stock picking alone.
At its simplest, it is a process that involves dynamically increasing exposure to undervalued asset classes and decreasing exposure to overvalued asset classes.
Play to your strengths
Asset Allocation is a portfolio management technique that provides investors with the potential to add value above and beyond most individual fund managers.
Most funds are constrained to a narrow asset class benchmark and do not have the ability to engage in asset allocation. Thus the investor who does use Asset Allocation has a KEY advantage through greater alpha generating opportunities than an institution or competing investor who is asset class constrained.
The ability to dynamically adjust asset classes could be the difference in helping investors to potentially both reduce risk and increase returns.