Asset Allocation, Research Paper Example

Asset location is what precedeany decision that specifically targets securities. All investment decisions employ aspects of asset allocation as it is the backbone of a successful investment portfolio. The importance of asset allocation cannot be understated as it has been found to account for up to 91% of variation experienced between different investment portfolios. For this reason, asset allocation has become one of the most important determinant s of success in the financial industry.

The success of a given portfolio is determined by the overall risk and return its investments realize. The mix of assets an investor decides to undertake are a direct representation of their desired goals. In achieving this goals, investors employ different strategies that help them achieve specific objectives. There has been considerable development of tools to enhance asset allocation. These tools represent the different strategies that define the philosophies of a given investor(s).

Asset Classes

Assets classes determine how diverse a given portfolio has been developed. There are three main categories of assets; stocks, bonds and cash. An investor would generally diversify their portfolio by spreading their investment between these two classes of assets. The amount of diversification that an investor employs is determined by two main factors; (1) financial objectives and (2) risk. An investor’s financial objective is fundamentally the expected rate of return oninvestments made. The return on investments areusually geared towards matching a given specific financial goal or commitment. The kind of investments an investor makes attracts a given rate of risk as a result of movements of market forces such as inflation and interest rates. Every given investor is comfortable with exposing their investment to a certain amount of risk. An investor’sinvestment should be able to realize the investors desired financial goals with minimal variance and/or volatility.

There are a number of strategies that have been developed defining and matching different investor behaviors.

Mean-Variance Optimization (MVO)/Strategic Allocation Strategy

This is a statistical and mathematical strategy that employs the determination of weights for every given asset or security. These weights are applied to mathematical formulae to determine the optimal return relative to the expected return of risk. The optimization may also target to minimize risk relative to a given expected rate of return. The application of the MVO technique requires given statistical information on the given assets. These include;

• security expected returns
• expected standard deviations
• expected cross-security correlations

This model was developed by Harry Markowitz. At its inception, the model was employed on individual securities. Even though the model was widely used on a singular asset, it was not effective. However, the model has since been used on different asset classes. This made estimation of assets more accurate as opposed to the application on singular assets. This method is now used on asset classes owing to the availability of a wide range of assets available. This is largely owing to the willingness of investors to venture into foreign securities.

The application of weights in the allocation of assets is largely referred to as the strategic allocation of the portfolio. For this reason, MVO is also referred to as the Strategic allocation Strategy. The strategic allocation strategy employ a buy-and-hold philosophy. This philosophy does not consider the effect that the changes in the values of the assets have on the initially established mix of assets.

Constant Weight Asset Allocation (Dynamic Asset Allocation)

This strategy employs adjusting and revaluing the weights employed in determining optimal return, based on the shifts and changes within the market. This strategy fundamentally aims to cushion or protect returns on investment from the movement of market forces that may otherwise be detrimental to return and increase risk. For this reason, it is considered as insurance of a given asset’s return as it shields the portfolio from the downside risks that the portfolio potentially faces. The return distribution of a call option is one of the most commonly used form of portfolio insurance.

Portfolio insurance has widely been criticized owing to the fact that it has been found to be inefficient and inherently increase risks within the market. These strategies have been found to be procyclical in nature and have been attributed with increasing market volatility. This was demonstrated by the 1987 market crash.

Tactical Asset Allocation / Active Asset Allocation / Market Timing

Active asset allocation is deviating from the strategic asset allocation at the event that an investor’s short-term forecasts diverge from the long-term forecasts that have been used to formulate the strategic allocation. Using this technique can enhance the returns realized from a portfolio, given the investor has the ability to generate short-term forecasts that have little to not error.

Active asset allocation models employ the policy of purchasing an asset when its price depreciates. However, this poses a potential risk of reducing diversification and increasing risk. This would largely stem from the potential overweighting or underweighting of certain assets. This strategy is quite similar to insuring a portfolio.

Exchange Traded Funds (ETFs)

Exchange Trade Funds are very popular exchange-traded products as a result of their low costs, stock-like features and tax efficiency. These securities usually track the security index of a given pool or basket of assets. However, the security is traded like a normal stock in the exchange market. These securities offer the investor the ability to diversify through an index fund, but remain with the option of either buying on margin and purchase a minimal number of shares or selling short.As each fund has its own expense ratio, ETF’s possess a much lower one than mutual funds.

ETFs are most effective for passive management. This is because the investor would only be required to make minimal adjustments to the fund to ensure it meets the desired return objectives. This is much simpler than actively traded funds that require the investment manager to constantly make adjustments in a bid to outperform the market. As a result, these funds attract low costs which translate to lower management costs, making them cost efficient.

ETF’s are considerably flexible owing to the fact that they are traded throughout the day, and are thus priced continuously. With the option of selling short or buying on margin, the investor receives a greater deal of diversification, reducing risks on his investment.

Mutual Funds

Mutual funds are fundamentally a collection of investors who pool their resources towards creating a portfolio of specific real estate, stocks, bonds or other securities subject to an agreed upon charter. This charter maps out the philosophy to be employed in investing the pool of money collected from each investor. Profits are shared between all investors as stipulated in the fund’s charter. Profits are earned according to the dividends realized on stock and/or the interest earned from bonds. In the case where the fund sells a given asset and makes profit, this is recorded as a capital gain, which may be passed on to the fund owners. However, if the capital gain is not passed on, the share value of the fund increases and the investor has the option of selling their shares in the fund at a profit.

Mutual funds have numerous benefits. The main advantage of a mutual fund is the professional management of the fund. Most investors have the resources to make investments but lack the know-how of keeping investments profitable through reading the market. Purchasing mutual funds offers the investor professional management of their investment.

Mutual funds also offer the investor diversity. This is because the fund charter of every given mutual fund would always look to increase diversity in order to minimizing risk. By spreading the investments between a number of stocks, bonds and real-estate, investors can be assured of minimal risk exposure to their investments. Mutual fund buys and sell securities in bulk. This allows for the fund to incur low transaction costs. These low transaction costs would reduce the management costs of the fund, given stocks are purchased in bulk. These funds are also relatively liquid.

Mutual funds also have a number of disadvantages. Investors may be skeptical about the professional competency of a fund manager. Even in the event a fund realizes losses, the fund manager still receives their wages. These funds attract tax in the form of capital-gains tax. This tax is imposed every time the fund manager sells any security.

Closed End Mutual Funds

These funds contain a portfolio of securities that are managed by a professional fund manager. The fund sells its shares at a one-time public offering, after which they are no longer offered. The fund’s shares are traded in a formal exchange and the price of its share in the market is determined by the laws of demand and supply. As such, the net asset value (NAV) of the fund does not determine the value of the fund’s shares. However, the number of shares for this fund is fixed.

Owing to the closed nature of the fund, its prices tend to be very volatile. As such, they are mainly purchased by investors who are not risk-averse. Because the market determines the fund’s share price, it is open to a lot of influence by market forces, making them riskier investments.

Open-End Mutual Funds

These type of funds are also made up of a portfolio of securities managed by a professional fund manager. The fund sells its shares in a public offering but have the ability to issue out new share at any given point in time. This create a continual share offering to the public. The fund may also repurchase its shares from investors as the market responds to the forces of demand and supply. The number of shares can therefore fluctuate on a day-to-day basis.

The value of the fund’s share is determined by the net asset value (NAV) of the fund divided by the number of shares.These type of funds offer the investors great flexibility. The investor has the ability to determine when and how they purchase the shares. Furthermore, the investor is never required to purchase the fund’s shares at a premium.

Master Limited Partnerships

This is a publicly traded limited partnership. This partnership is made up of two parties; (1) the investor who offers the capital for investment, and (2) the professional manager who manages the investment of these funds and receives compensation for doing so. The investor enjoys the advantages of a limited partnership but retains the aspect of liquidity as they can trade their partnership as normal stoicks.in order for a firm to qualify as a master limited partnership, it has to receive 90% of its income from investments that relate to natural resources, real-estate and commodities. This type of investment receives the tax benefits of a limited partnership where taxes are imposed only on distributions received.

Commingled Instruments

These securities entail the mixing of different funds and packaging them as a single fund. This type of fund is exempt from the ordinary requirements of a mutual fund. The fund is managed by a professional fund manager. This fund is limited to purchase by institutional investors who are engaged in a 401(k) plan. These funds are not publicly traded making information about them difficult to find. Owing to the fact that these funds are not publicly traded, it increases the investor’s risks as there is very little governance over the conduct of the fund manager. For this reason, commingled instruments are valued based on their performance in the past. The historical data provides the basis upon which the fund is valued, relative to prevailing market conditions.