As investors look through their investment performance statements both in and outside of superannuation, they should be keeping a close eye on the asset allocation of their investments.  Research shows that the mix of asset classes is the number one determinant of investment returns.  So what exactly is asset allocation and what should investors be doing to make sure the asset allocation reflects their needs?

The following provides a brief summary of this topic and is taken from our book - It's Time You Knew the Truth and our Investment Portfolios Basics document.

--------------------

When we look to build an investment portfolio, there are various 'asset classes' into which we can invest your money.  These include cash investments (like bank accounts), Australian share investments (which is an investment in Australian companies), property investments and international share investments (which is investing in overseas companies in the United States, Europe and Asia).  There are even obscure asset classes like 'taxi licenses', 'wines' and 'art' - although we steer clear of these. 

The first and most important stage of the process is to carefully consider what mix of assets is best for your portfolio.  This will be different for every person, and research shows that this mix of asset classes is the number 1 determinant of investment returns.  That's why we focus on getting it right. 

In the Financial Analysts Journal in 1991, Brinson, Singer and Beebower provided an update to their 1986 article 'Determinants of Portfolio Performance'.  This study examined 91 US pension funds during the period 1974 to 1983.  The study looked at three factors to see which made the biggest difference to portfolio returns.  The first factor was the asset allocation.  The second factor was security selection, which were the investments within each asset class that the managers actually chose.  The third factor was market timing, which was the ability of the portfolio manager to move from underperforming asset classes to better performing ones.  That is, choosing the best time to invest in each asset class.

The results were conclusive, with over 90% of the variation in returns explained by asset allocation.  4.6% of the variation in returns was explained by security selection and 1.8% by market timing. 

For our purposes we use this study to justify a focus on asset allocation as being the key driver of portfolio performance.  We also use it to justify why we are not going to try to use market timing, moving from asset class to asset class, to try to increase performance.  The article shows that this is difficult, if not impossible to achieve.  So our approach is to build an appropriate long term asset allocation, and then stick with it over time.

More recent studies by Ibbotson and Kaplan (2001) 'Does Asset Allocation Policy Explain 40, 90, 100 Percent of Performance?' published in the Financial Analysts Journal in 2001 and 'Another Look at the Determinants of Portfolio Performance' by Craig French and available at ssrn.com, found that asset allocation policy explains more than 90 per cent of the variation in total portfolio return.  This supports the original study of Brinson, Singer and Beebower.

Take a look at our web page - Our Research Based Approach - Importance of Asset Allocation for more details and links to the actual studies.

To get this asset allocation right we very keenly focus on what income you need to draw from your portfolio, the time frame you intend to invest for and your investment experience.  We also take into account our assessment of your attitude towards investment volatility (the ups and downs likely to be experienced by your investment portfolio) and your desire for investment profits.

We categorise all of the investments that are available into two general categories - defensive assets and growth assets.

Defensive assets are generally cash and fixed interest investments.  Cash investments are bank account investments.  The fixed interest investments we use are similar to bank term deposits.  These investments provide a steady income stream, with the safety that the money invested in these asset classes is secure.  You might say that these are the low risk, low return investments that will help you to sleep soundly at night.

Growth assets classes include Listed Property, Australian shares and International shares.  Listed property investments are listed on the stock exchange, with the underlying assets being office buildings, retail shops and industrial sites (for example Westfield Shopping Centres).  Owning Australian shares means that you are a part owner of a business, or portfolio of businesses listed on the Australian stock exchange (businesses like BHP and Telstra).  Owning international shares means that you are owning businesses listed all over the world - the US, Europe and Asia.  In owning all of these assets you would expect to experience significant fluctuations (volatility) in asset values.  In some years they will rise sharply in value, other years they will fall in value.  Importantly, the average return from these asset classes have been higher than the returns you get from investing in cash and fixed interest investments.

Unfortunately some fund managers, including industry super funds, do not apply such a pure definition of defensive assets as mentioned above.  They throw in "income" securities and absolute return funds (hedge funds) that when performing well produce income streams often above those of traditional cash and fixed interest securities but unfortunately they do so by carrying a lot more risk.  Two recent articles by Scott Francis look at this very scenario and point out the importance of getting your defensive allocation right.

Bookmakers Caught by MFS - (contribution to James Kirby's article) - Its investment in MFS was classed as low-risk, but the truth was otherwise and could bring NSW Bookmakers Super's first loss in its 30 year history.

Prickly Hedges - If you are relying on a multi asset class fund manager, you need to be aware of - and comfortable with - how they are managing your underlying portfolio.
 
--------------------
 
How do we apply this?
 
The first and most important task when establishing an investment portfolio, including within superannuation, is to ensure that the asset allocation meets the income needs and risk profile of the individual investor.  We carefully consider this in consultation with our clients before looking at which investments should be used within each asset class.
 
Please see our Investment Portfolio Basics web page for more details.