The art of dynamic asset allocation

There is no ideal asset allocation. This is because resources – particularly costs and knowledge – dictate that every fund’s position will be different, according to Carl Hess, global practice director of Towers Watson Investment. If Hess was starting with a blank slate, he would advocate about 10 different positions – from equities, to skill, to commodities – among return-seeking assets. “This is more diverse than anyone has been to date,” he says. “Good allocation has a lot to do with resources, internal and external, but if a fund is willing to raise the game, there are a lot of opportunities,” he said. Asset allocation depended on the time horizon of the investor, Hess said, explaining that an endowment with a long time horizon would be very different to a defined benefit fund that was riskaverse or is closing. But, he said, probably the most important criteria affecting appropriate asset allocation is resources.

“Cost is one resource, knowledge is another. It is a competitive world and investors need flexibility and the speed to act, which is an organisational effectiveness issue,” he said. Towers Watson ran a model portfolio – in which allocations were made according to the return drivers of underlying assets – and Hess believed it would be a useful exercise for investors. “We are looking at the return premium, insurance premium and illiquidity premium. We take an investment opportunity, have some measure of how to map that on to return drivers, then overall we see how much of the portfolio is allocated. Qualitatively it is not very complicated – quantitatively it could be – but it’s a useful mapping exercise,” he said.

He also advocated the somewhat opportunistic method of dynamic strategic asset allocation (DSAA), which focused on midterm investment opportunities (three-to-five years), compared with strategic asset allocation (10 years) and tactical asset allocation (a matter of months). According to Towers Watson’s philosophy, DSAA can act as another source of risk and return in the portfolio. It saw the primary focus of DSAA as adjusting risk exposures, which requires a broad opportunity set, and made broader changes than asset class tilting. It also requires a disciplined real-time decision-making process. “DSAA is pretty wide, but we are not making that many calls. We wait for evidence,” Hess said. An example of DSAA, implemented by the consultant for a client in April 2008, was a 20 per cent allocation to global investment-grade credit, with the allocation coming equally from equities and bonds (the portfolio’s long-term allocation to the asset classes was a typical 70/30 split).