The little known, but powerful, reality is that around 80% of returns generated from an investment comes from simply selecting the “right” asset class. In this Portfolio Construction post, we introduce the concept of Strategic Asset Allocation and describe how investors can practically use ETFs in their investment portfolio.
Most people like to think about picking “winning” stocks. Maybe its human nature, or maybe its because Australians are (supposedly) a nation of punters. Although picking good stocks has the potential to boost investment returns, studies show that its by no means the most powerful investment tool.
The little known, but powerful, reality is that around 80% of returns generated from an investment comes from simply selecting the “right” asset class (source: Ibbotson).
The difficulty in trying to select and invest in the “best” asset class or classes is that these change over time – and often these changes (for better or worse) aren’t immediately visible to investors. The best performing asset class can change from year to year, and buying (or selling) prematurely or “after the horse has bolted” can undermine overall gains.
Diversification to increase returns and reduce risk
One way to ensure you have exposure to an asset class as it starts to perform well is to include it in your portfolio over the long term. Having a diversified portfolio also reduces the risk of loss when one (or more) of your investments performs poorly.
Instead of holding only a few assets – and actively trying to reshuffle investments to stay in front – this approach builds diversified portfolios from a broad range of asset classes. A diversified portfolio will usually have a mixture of Australian equities, international equities, direct property (or property securities), fixed income, cash and alternatives, including commodities such as gold and agriculture.
Unless you have very deep pockets, building a diversified portfolio means you need to ration the amount you invest in each asset class – so evaluating the relative allocations to each asset class is just as important as deciding which asset class or classes to invest in.
What is Strategic Asset Allocation?
“Strategic Asset Allocation” (SAA) is a system which builds a diversified portfolio using past (and predicted future) asset class performance to set the overall allocations to each asset class. SAA uses a combination of “top down” (big picture themes on the economy) market analysis to identify desirable asset classes, and “bottom up” (asset class or company specific) analysis to determine whether an asset is cheap or expensive. SAA allocations will change over time as the return and risk profile of asset classes change.
Its common for SAA to produce asset allocation recommendations which vary depending on the level of risk that an investor wants (or needs) to assume. So depending on the “risk profile” of each investor, the relative allocations to each asset class will vary. Cash allocations will be higher in conservative investment portfolios than, for example, it would be for an aggressive investor.
Strategic Asset Allocation – what are the risks?
Although the mix between more risky assets (like shares and property) and less risky assets can change over time, with allocations to cash increasing as market risk rises, SAA will always involve some exposure to more risky assets. That’s because SAA assumes that an investor will be able to retain their exposure to risk assets for the long term, with the hope that strong returns in good years will outweigh the bad returns in poor years.
ETFs are a very good tool by which to obtain exposures and implement investment decisions in each major asset class within an SAA portfolio. There are very few other ways to gain instant, diversified exposure to asset classes and exposures in a low cost, transparent and liquid manner.
For example, the table below shows the potential applications of BetaShares’ ETFs within a diversified portfolio comprising only ETFs.
Source: BetaShares. Illustrative only. Not a recommendation to adopt any particular investment strategy. Before making an investment decision, always consider the relevant PDS, your particular circumstances and obtain financial advice.