July 4th 2011: What Make Strategic Asset Allocation Work?

07/05/2011 Share 0 comments

In the previous newsletter, we set out to seek intuitions behind the portfolio strategies used by MyPlanIQ. Strategic Asset Allocation (SAA) derives a portfolio allocations based on the investor's risk profile. The allocations are the target percentages for portions invested in major asset classes. Major asset classes are U.S. equities, Developed country equities, emergin market equities, Real Estate Investment Trusts (REITs), Commodities, Fixed Income (or debts, bonds). Periodical re-balancing (such as monthly or quarterly) first picks top funds available in a plan (such as a 401K) in these asset classes and then invest in these funds according to the preset target allocation percentages. Portfolio target allocations are changed only when the investor's risk profile is changed. This strategy is a long term strategy.

So what make SAA work, even in long term (such as 10 years or longer)? The following are the key intuitions/factors:

• Diversification: since these major assets (thus the funds in these asset classes) are not entirely correlated to each other (meaning when one goes up, the others do not necessarily go up or vice versus), invest in various assets will make the portfolio less volatile or risky. This concept is very easy to understand.
• Equally important but less understood is that asset classes invested should have positive and reasonable expected (average) returns in long term. It does not make sense to hold an asset that produces negative returns in long term. Let's take a look at a U.S. equities (stocks) index (or a diversified mutual fund), can we intuitively justify that it produces positive returns on average in long term (such as 10 years)? We all know company stock prices are related to their underlying economic earnings or dividends (again in long term). So what makes stock market as a whole delivers positive average returns? The answer lies in that the stock market in the U.S., developed countries or emerging markets is positive related to the GDP of a country or countries. So in a long term prosperous country, holding equities is rewarding to their owners. Furthermore, since a company owner would demand higher returns compared with just simply putting money into a bank (otherwise, the owner would just simply closes the company and get similar or better returns in a bank, for example), equities in general return more than cash or even safer fixed income. Notice it is not always intuitively correct to hold equities in any country since the country's economy might not be growing at all (think about many poor African countries or even China 30 years ago).
• Periodical re-balancing: this is essentially buy low and sell high.

Due to space considerations, we leave out other asset classes. The other critical factor is the fund selection method. We will leave out these for a future newsletter.

We encourage curious minds to explore further in this topic in our forum. 

Market Overview

Markets staged remarkable rally last week, risk assets regained top positions in our asset trend ranking. Some key observations:

• All the risk assets are ranked higher than fixed income assets. An obvious risk on mood in the markets.
• Even among fixed income ETFs, those in the risky end such as high yield bonds, emerging market bonds and international bonds are ranked higher than other more stable bond funds.
• Commodities are now the weakest among risk assets. This again is positive to stock markets.

Though commodities have a correction, we do not see any fundamental events that make us change our longer term belief: the global government stimuli and a long term U.S. weak dollar policy will make commodities costly in the future.

For more information on how these assets are ranked, please see here. 

MyPlanIQ's top Smart Money Managers' asset allocation has swung back to U.S. stocks: the allocation to U.S. stocks increased to a record high 78.5% in a year on last Friday.  For more information, please refer to MyPlanIQ SmartMoney Indicatorspage (click on larger chart link such as this for better reading).

Benchmark Portfolios

It is a good time to have a half year review on Six Core Asset ETFs. From the following table, we can see that the Strategic Asset Allocation moderate portfolio beats Vanguard Balanced Fund Index (VBINX) while the Tactical Asset Allocation moderate trailed both S&P 500 (Vanguard 500) as well as the Strategic Asset Allocation portfolio. However, the tactical one still beats VBINX. This is expected as markets fluctuated in the first half year.

For more detailed comparison, see here.

Recent Development

We have received many emails regarding this month end re-balance activities. Please do check our Support forum often and help each other out by posting your questions and answers there.

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How can we improve this newsletter -- we value your inputs --Thanks to those who have already contributed -- we appreciate it.

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