Nearly every financial textbook says that the No. 1 decision investors have to make that impacts investment returns is asset allocation. Asset allocation, or asset mix, as it is often referred to, is the composition of your overall portfolio — what percentage of your portfolio that you direct to be in cash and equivalents, fixed income, and equities. We agree that this is a very important element in establishing your financial goals and we review this with clients at every meeting.
When we first begin working with new clients, we spend a significant amount of time determining their strategic asset allocation. Over time, we always need to confirm the strategic asset allocation, but we will also periodically make tactical asset allocation decisions. Below we will explain the difference between strategic and tactical asset allocation.
Strategic Asset Allocation
A strategic asset allocation is one where the mix between cash, fixed income, and equities is established based on the client’s underlying profile — their cash flow needs, age/time horizon, investment objectives, and risk tolerance. Typically, the lower the client’s risk tolerance, the higher the need for cash and fixed income.
Strategic asset allocations have become more challenging over the last decade as retirees can no longer get appropriate investment income by allocating the majority of their investment savings toward fixed income investments.
Many structured investments discuss the advantages of strategic asset allocation as it is tailored to a pre-selected asset mix. This automation can also be a negative as potential opportunities are completely ignored by having too strict of an adherence to a strategic asset allocation.
Tactical Asset Allocation
A tactical asset allocation is an active asset allocation strategy where the mix between cash, fixed income, and equities changes based on market conditions. Valuations of stocks can be an example where tactical asset allocation decisions become more important.
Investors are often thrilled when the stock market is hitting all-time highs, and stocks are hitting record levels. From a portfolio manager’s standpoint, we are always looking at valuations, earnings levels, economic indicators, political factors, etc., when deciding whether to underweight, neutral weight, or overweight equities.
We often see clients are thrilled, or feel like investing is easy, when the markets are doing really well. History tells us that it is at these points in time that investors are approaching maximum financial risk. It is also often at these points that investors should determine if a tactical asset allocation decision of underweighting equities is prudent.
On the flip side, when markets decline rapidly, as a result of desperation and panic, this often creates the point of maximum financial opportunity. In my years of experience as a Portfolio Manager, putting your cash to work and temporarily overweighting equities after periods of capitulation and despondency has always resulted in our clients being rewarded once markets stabilize and recover.
Investment Policy Statement
All of our clients complete an Investment Policy Statement (IPS). This document is signed at the beginning of working together and it is mandatory that we update this document frequently. The IPS is also updated when there is a material deposit, withdrawal, or life event that occurs which can alter the makeup of how your funds are positioned and invested. The IPS outlines the cash flow needs of each client and where these cash flows will come from — both periodic and lump sums — over the period of the IPS.
Asset Allocation
As stated above, asset allocation is the process of determining the percentage of your investments that should be invested among cash and equivalents, fixed income, and equity.
To help illustrate asset allocation, we will use a client who does not require any cash flow from their investments. Below, we have input the asset allocation for this example client, who is invested in our Greenard Index Moderate Growth Model Portfolio.
|
Asset Class |
Strategic Asset Mix |
Asset Mix Guidelines |
|
|---|---|---|---|
|
Minimum |
Maximum |
||
|
Cash and Equivalents |
0 % |
0 % |
40 % |
|
Fixed Income |
30 % |
10 % |
50 % |
|
Equity |
70 % |
50 % |
90 % |
The table above lists the three main asset classes, along with the strategic asset mix. The strategic asset mix is listed as 0 per cent cash and equivalents, 30 per cent fixed income, and 70 per cent equities. Adjacent to the strategic asset mix are the permitted asset mix guidelines. Essentially, this section is equivalent to us making tactical asset allocation decisions.
For a client who does not require cash from their investments, the optimal asset mix would indicate 0 per cent for cash and equivalents. In normal market conditions, we would want to remain fully invested for optimal returns. Even though the optimal asset mix indicates 0 per cent, we would always put the range for cash to between 0 and 40 per cent. As a Portfolio Manager, we have the flexibility to increase cash up to 40 per cent if we felt it was prudent to do so — this would be an example of a tactical asset allocation decision.
Fixed income, in the above example, has an optimal asset mix of 30 per cent — the strategic allocation. We could reduce fixed income down to 10 per cent or increase the fixed income up to 50 per cent, depending on the current market environment — the tactical asset allocation decision. The IPS has a 20 per cent range on either side of the strategic asset mix to enable us to make tactical asset allocation decisions while staying onside with the IPS.
Lastly, equities for the Greenard Index Moderate Growth Model Portfolio have an optimal asset mix of 70 per cent, which is the strategic asset mix. We could reduce equities down to 50 per cent or increase up to 90 per cent. As you can see by the table, and similar to fixed income, the IPS has a 20 per cent range on either side of the strategic asset mix to enable us to utilize tactical asset allocation.
Modifications to Strategic Asset Allocation
Typically, the strategic asset allocation percentages are established for the long term. They are meant to give guidance to your portfolio manager on how to invest your money. Done correctly, it should also provide comfort that you are allocating your portfolio based on your investment objectives, risk tolerance and time horizon.
Having said all that, as a portfolio manager, we have had to sit down with clients several times in the last decade and discuss proposed changes to the strategic asset allocation. The three main situations that stand out that have resulted in us having discussions with each client in the last decade are: decline in interest rates, economic conditions, and wealth accumulation.
1. Decline in interest rates
To illustrate, let us look at a retiree with $1 million who, ten years ago, set up a monthly pay five year laddered guaranteed investment certificate (GIC): $200,000 maturing in year one, $200,000 maturing in year two, $200,000 maturing in year three, $200,000 maturing in year four, and $200,000 maturing in year five.
There was zero risk to the underlying capital and they simply lived off of the interest. This investor could average a five per cent rate of return, and live off of the $50,000 in interest income, CPP, and OAS without even touching the capital. Today, that strategy doesn’t work.
The income on a similar monthly pay five-year laddered GIC is less than $12,000 annually. This investor would have had to make a change to the strategic asset allocation by including equities and reducing fixed income to maintain the same potential investment return.
2. Economic conditions
One of the main reasons we have suggested changes to the strategic asset allocation over the years relates to economic conditions.
Since early March 2020, we have had discussions with each client in our Greenard Index Moderate Growth Model Portfolio, which has resulted in us shifting the fixed income component up 10 per cent and reducing the equities down 10 per cent. We felt that this was a prudent move for clients to make as economic indicators have declined and the pandemic continues to add future uncertainly.
3. Wealth accumulation and life events
We have worked with a number of clients who have accumulated significant wealth. Some have received large inheritances or sold businesses. Many have sold real estate holdings or have accumulated wealth simply by saving regularly and investing prudently. The strategic allocation decision when an investor is younger or accumulating wealth is often geared for maximum growth.
Our wealthiest clients have both moderate growth and capital preservation as primary investment objectives. Obtaining maximum return on the wealth accumulated often becomes secondary to ensuring the capital is protected. The strategic asset allocation is often shifted more conservatively as our clients age or encounter a life event.
Recent Tactical Asset Allocation Decision
Every year, there is news or events that occur that can cause concern and worry. In the majority of cases, these concerns and worry dissipate with time. As a portfolio manager, we can make a tactical decision to raise cash if we feel it is prudent to do so. Often, we have to assess a situation in the scope of what we feel investors will do, not what they should do.
The latest tactical decision we made was to increase cash in the Greenard Index Model Portfolios to approximately 15 per cent prior to the upcoming U.S. presidential election. We do not intend to be at this level of cash longer term; however, if the markets have an irrational pull-back before, during, or after the election then we will view this as an opportunity to purchase quality investments at lower levels.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138. greenardgroup.com
