INVESTORS in Singapore are relatively new to concepts like asset allocation and portfolio management. That's because investments are mostly sold on a single product basis. These products often cater to investors' two main emotions - fear (capital protected products) and greed (latest high return story). Persuasively marketed, these flavour of the month products have been enthusiastically received.
Playing it safe: Asset allocation reduces risk as investments are spread over different asset classes
But in my opinion, a well-thought-out asset allocation strategy is superior to the hodge-podge approach of investing, buying products based on marketing. Asset allocation has one important function - it reduces risk as investments are spread over different asset classes.
Here's a quick recap of the advantages of asset allocation as expounded by its founder, Nobel laureate Harry Markowitz: While the overall return is a weighted sum of its parts, the overall risk - or volatility - of a portfolio is actually less than that of the sum of its parts.
Two technical terms explain this reduction in risk: covariance and correlation, which essentially measure the relationship between two investments over time. For example, if the performance of Investment A and Investment B are closely related (ie, when A rises 5 per cent, B also goes up 5 per cent, and when A suffers a loss, so does B), they can be said to be highly correlated.
The goal of the asset allocator is to combine investments that have a low correlation with each other, ie, they behave differently under certain circumstances. Putting them in the same portfolio will result in more stable overall returns.
The goal of the asset allocator is to combine investments that have a low correlation with each other, ie, they behave differently under certain circumstances.
Let's see how this works in a simple two-asset portfolio. Three portfolios are created based on the expected returns, risk (measured by standard deviation) and correlation figures for global bonds and global equities
(Table 1). The first has an 80-20 allocation (80 per cent bonds and 20 per cent equities); the second, 50-50; and the third a 20-80 allocation. Some interesting observations can be made based on the results. A conservative investor with an entire portfolio of global bonds, for instance, would benefit by allocating 20 per cent to equities. The equity portion would add 0.6 per cent of return for a marginal increase in risk (from 6 to 6.02 per cent). At the other end of the spectrum, an aggressive investor fully invested in equities could significantly reduce the volatility of his portfolio by allocating 20 per cent to bonds.
So how do you go about allocating assets in your portfolio? The first step is to determine the efficient frontier - another Markowitz concept - which is the optimal risk-return balance. This entails identifying all the investible asset classes, before coming up with their expected returns, standard deviation and correlation figures. An optimisation process is then carried out to determine the ideal weighting in each asset class for different risk-return profiles.
Risk and return objectives
Once these optimal portfolios have been identified, the next step is to determine which allocation along this efficient frontier you should be investing in. Your risk and return objectives should be the two main factors in making this selection. Do you require higher returns? If so, then you will probably need to be more on the right hand side of the risk-return curve. This, however, needs to be balanced against how much risk you can stomach. Conservative investors, for example, would be better off sticking to lower return, and hence lower risk, allocations.
Besides risk and return, another important factor to consider is your investment time horizon. Generally, the longer your time frame, the more risk you can afford to take. In addition, a more conservative allocation is recommended should you have any liquidity requirements, like a regular drawdown on your investments to fund retirement expenses.
The only time people start thinking about risk is when a blow-up occurs (China Aviation Oil, Amaranth, etc). By then, it is usually too late to take any remedial steps.
Once you've determined an appropriate asset allocation strategy, the next step is to fill it with suitable instruments. Unit trusts and other collective investment schemes are our preferred instruments because we think they are the best source of diversified exposure to markets. Many local investors, having had bad experiences in the past, may be leery of unit trusts. I believe that the problems with unit trusts can be overcome with timely asset allocation calls coupled with careful fund selection and monitoring.
Indeed, being able to select the better-performing funds can often add precious additional returns to your portfolio. The problem, however, is that there are over 600 unit trusts to choose from. So how do you sieve out the wheat from the chaff?
Let's say that you need to find a good global bond fund. The first step would be to isolate all the global bond funds available in the market. Thankfully, there are now a number of online websites and tools that allow you to perform this exercise relatively easily (www.fundsingapore.com; www.fundsupermart.com; Lipper leader tables, etc). Note that you will probably need to refine this list as different providers have different methods of classifying funds.
Pulling out all the global bond funds from the fundsingapore website, for instance, would result in 42 'global bond' funds, some of which are actually capital protected or global high yield unit trusts. Table 2 shows an edited list of global bond funds that fit my requirement. The table also shows the absolute performance figures of the 18 funds and their relative rankings over different time periods.
One approach could be to simply select the best fund based on the numbers, though the question would always be, what time period should you be looking at? In this case, the Invesco Global Bond fund has been the top performer over the past six months, while the DBS Shenton Income and the Templeton Global Bond funds stand out over the longer term.
Assessing fund managers
Note that selecting the best funds purely on the numbers may not be the best move, since you are relying on historical figures. As we all know, past performance is no guarantee of future performance. Hence, it is arguably even more important to assess each fund manager based on qualitative factors, evaluating their investment methodology to uncover how they go about delivering good returns consistently. This qualitative due diligence can be time-consuming. For instance, I believe that regular dialogue with the fund managers is necessary in order to better size them up.
If the process sounds like too much effort, think about the potential benefits of adopting a proper asset allocation methodology, namely, reducing portfolio risk. People tend to overlook investment risk in their chase for higher returns. In fact, the only time they start thinking about risk is when a blow-up occurs (China Aviation Oil, Amaranth, etc). By then, it is usually too late to take any remedial steps.
So the next time someone tries to sell you an attractively packaged product, ask yourself if you can stomach the worst case scenario and whether the product fits your overall asset allocation strategy. Don't be afraid to walk away if your answer is negative to both questions. You'll sleep much better as a result.
The writer is chief investment strategist of Providend.
