A Study on Global Asset Allocation
Research shows that nearly 80% of the returns generated via investments are made through the right choice of asset allocation. Whilst this statistic might seem easy to execute on the outside, taking a deep dive into how asset allocation works is not relatively straightforward. Even the most successful investors are not able to repeatedly perform asset allocation in the most efficient way. Investors want low risk but at the same time, want to maximize returns. This is not easy to achieve due to the trade-off that exists between risk and return. This is where asset allocation, specifically global asset allocation, comes into play as it can help investors in achieving a maximum return for a given level of risk.
The reason for investors to diversify globally across asset classes is that different asset classes perform at different times. This is due to changes in expectations of the economy and how companies are anticipated to perform in the future and accounting for geographic differences. There might be a particular year or two where equity might outperform other asset classes and there might be a year where other asset classes would outperform equities. The reason for asset allocation is that despite having access to historical data, one cannot easily predict which asset class would perform the best in a given year. This is where asset allocation comes into the picture and is why a sensible investor should have a mix of different asset classes in their investment portfolio.
Global asset allocation is an extremely overlooked aspect when it comes to investing in India. Plenty of Indian investors tend to diversify their investments across various asset classes such as equity, debt, commodities, and real estate but only tend to do so within India (home country bias). Others who manage to diversify their portfolio across different countries tend to do so only amongst one asset class, notably equity, ignoring global diversification of other asset classes. Despite global asset allocation providing numerous benefits to investors, it is still in its infancy in India. One of the primary reasons for this is a lack of knowledge amongst investors that doing so is possible and also a lack of knowledge regarding platforms that allow Indian investors to diversify their investments across different asset classes in different countries.
Global asset allocation has plenty of benefits for investors. The most obvious benefit is risk mitigation. Here, it is important to realize that risk is mitigated not only because the investment is diversified across different asset classes, but also because it is spread across different geographic regions. Diversifying across asset classes means that the investor’s portfolio would comprise of assets that have a low/negative correlation with one another, so when one asset class moves down, other asset classes would likely move either in the opposite direction (i.e. go up), be flat, or move down but at a lesser rate. This means that the investor’s portfolio would most likely never be in a situation where all of their holdings would be falling at a rapid rate at the same time.
Looking at the correlation matrix above, we can see a negative correlation between GOVT (US government bonds) and the first five rows in that particular column. VT, SPY, VEA, VWO, and FM are five different equity ETFs and a negative correlation between equity and debt in this context implies that the two asset classes tend to move in opposite directions, providing a hedge to a portfolio comprising of even just these two asset classes. Other asset classes such as debt and commodities also have a negative correlation (as seen between FIXD (total world fixed income market) and PDBC (commodities ETF)). Hence, based on the illustration above, it is evident that having a portfolio comprising of different asset classes such as equity, debt, and commodities does provide downside protection.
Apart from diversifying across asset classes, diversifying across geographic regions also proves fruitful as you get the opportunity to mitigate country-specific risk. Individual countries might face currency risk, interest rate risk, and political risk and those reasons are capable of bringing turmoil to a country’s equity, debt, and real estate markets. Apart from these reasons, other reasons such as the inflation rate, unemployment rate, and growth of the economy are factors affecting equity, debt, and real estate markets in a country. There are several instances when the markets of a particular country might be hit due to any of the above reasons and that is why diversifying across different geographic regions is extremely important in order to limit losses and protect capital.
In addition to the above benefits, global asset allocation allows investors to protect their investments from currency depreciation. As known, the US dollar is the most renowned currency in the world and everyone tends to compare their home country currency against the US dollar. In the context of India, the Indian Rupee (INR) has largely depreciated against the US dollar in the last three decades. Back in the 1980s, 1 USD was worth Rs. 8. Today, 1 USD is worth nearly Rs. 74. Had an Indian investor invested in any asset class in the US nearly three decades ago, they would have simply made more than nine times the return when the amount is converted to INR just due to the dollar appreciating against the rupee. Add to this the return that particular asset class delivered over this time frame, the investor would be better off had he/she just invested in their home country. By diversifying investments across different geographic regions, an investor protects their investments from currency depreciation that he/she might face if they just invested in one country and benefits from generating returns also because of currency appreciation of a foreign country compared to the investor’s home country.
In order for asset allocation to work in an investor’s favour, the investor’s risk profile needs to be assessed so that the portfolio can be specifically catered to his/her risk profile. An investor can be conservative, moderate, balanced, assertive (growth), and aggressive. Based on where they lie within these five segments, an investment manager can cater to their needs and provide them with a customized portfolio that matches their risk profile. In doing so, the investment manager strives to maximize returns but at the same time, ensures that the risk taken is at a level that the investor is comfortable with. For instance, if an investor completes a risk profile questionnaire and lies in the conservative category, the investment manager would ensure that their portfolio would strive to maximize returns only at a level of risk that they are comfortable with. A conservative investor would want to take on a very low amount of risk so their portfolio would predominantly contain fixed income instruments and commodities. In contrast, if an investor who completes the risk profile questionnaire lies in the assertive or aggressive category, their portfolio would predominantly comprise of equity and real estate instruments. Hence, the most important step in asset allocation is that the investor’s risk profile needs to be understood by both the investor as well as the portfolio manager. Simply trying to maximize return does not bode well if an investor’s risk tolerance is extremely low.
Due to the plethora of investment instruments such as equity, debt, commodities, and real estate, different weights can be given to each instrument in order to cater to an investor’s risk profile, financial goals, and time horizon that they wish to remain invested for. Using the Markowitz mean-variance portfolio optimization approach, a portfolio manager can try out different weights for each asset class and strive to maximize returns at a specified level of risk. The efficient frontier is the “set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return”.
In the above figure, any point that lies on the curve is considered efficient because it strives to maximize returns at that particular risk level. Hence, once different combinations of weights are tried out, a portfolio that lies on the optimal portfolio curve should be chosen rather than one that lies beneath it.
As indicated at the beginning, asset allocation is an extremely difficult skill for even the most seasoned investors to master. Since different asset classes perform at different time periods and timing the markets is not an easy skill, the importance of asset allocation cannot be overlooked. As discussed earlier, diversifying across asset classes on a global scale allows investors to mitigate home country risk as well as asset-specific risk. Also, investors can benefit from home currency depreciation against global currencies as investing in different countries would provide a currency hedge. In addition, knowing how to allocate assets according to an investor’s risk profile is an extremely important skill since that would mean that the portfolio constructed is catered to the investor’s risk tolerance and is in line with his/her financial goals. In conclusion, all the above instances show us the importance of global asset allocation and why it is extremely vital that it is done in the right way.
By Arhan Parikh (arhan.parikh@xumitcapital.com)
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Resources:
https://en.wikipedia.org/wiki/Efficient_frontier (Image link)
