According to modern portfolio theory, a portfolio's returns are largely driven by asset allocation.
Asset allocation relies on diversification to mitigate risk. But, as Lionel Martellini writes in "A better approach to risk management," for the Financial Times, "Diversification cannot be expected to work in market downturns when all correlations between risky securities and asset classes notoriously converge."
Nearly all asset classes dropped precipitously in 2008. In a typical economic environment, various asset classes perform differently, to varying degrees, than the stock market. The amount by which the performance varies is known as the correlation. Ideally, investment portfolios should be made up of noncorrelating asset classes -- to the extent that it's possible.
A new report from Mellon Capital illustrates that asset class correlation, among other variables, can change, which necessitates a change in asset allocation to ease volatility and increase returns.
According to the report, the failure of institutional investors to meet their return objectives is not due to the failure of modern portfolio theory but, rather, the static asset allocation mix that drags down returns in light of changing expectations.
Save for yearly rebalancing, asset class exposure in a portfolio based on an asset allocation model may not change for years -- and that is where the problem lies, according to Mellon Capital. A dynamic asset allocation strategy will take into account new variables and expectations in the economic landscape and adjust accordingly.
For instance, the report states that while diversifiers such as commodities and REITs provided diversification benefits in 2008, "inter- and intra-asset class correlations jumped higher following the Lehman failure."
Changes in correlation affect the portfolio risk and therefore the optimal asset allocation mix. Correctly estimating the correlation between asset classes and adjusting the portfolio as warranted leads to better risk management, according to the report.
The report is based on the experiences of institutional investors, but there may be some food for thought for individual investors as well.
A recent monograph from the Research Foundation of the CFA Institute aimed at investment managers also recommends reviewing asset allocation more frequently.
In a press release, "10 things the investment management industry should take into consideration following the financial crisis," the CFA Institute says:
Today’s markets experience more large swings in market valuations and change behavior in fundamental ways that affect the forecasts of entire asset classes and require dynamic asset allocation. However, while dynamic asset allocation holds the promise of higher returns, it is a source of risk given that it shifts assets dynamically from entire asset classes, leaving little margin for mistakes in timing.
Food for thought. I think the takeaway here is that the economic environment is constantly changing. After big shifts, it may be worth revisiting your asset allocation to ensure that your portfolio is optimized for current conditions.
What works for you?