Christian Nolting is the regional head of portfolio management and lead strategist for Asia-Pacific at Deutsche Bank Private Wealth Management. Based in Singapore, he is responsible for leading a team that advises the bank's clients on investment strategy, asset allocation and discretionary portfolio construction. His role involves monitoring portfolio managers on their investment strategies, performance and risk management.
He shares with AsianInvestor his views on the importance of asset allocation and explains why this approach could be beneficial for investors in the long-term.
Why is the concept of asset allocation becoming the focus among wealth managers and financial advisors?
Nolting: The asset allocation approach has been developed over the years based on various academic as well as practical studies. The essence of the approach is reflected in the words of Nobel laureate Harry Markowitz, who says: "A good balanced portfolio is more than a list of good stocks or bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies." This approach allows incorporation of tools of modern portfolio theory (MPT) which could be seen as the philosophical opposite of traditional stock picking. MPT is the creation of economists, who understand the market as a whole, rather than business analysts, who look for what makes each investment vehicle unique to achieve satisfactory performance. Overall client portfolios through this MPT approach can be analysed and optimised in line with the client's risk taking capability.
Most private banks would see value in the asset allocation approach for their private client portfolios. Theoretically, an appropriate distribution of wealth among different asset classes, with an individual strategy geared to the risk-return profile of the client being complemented periodically by dynamic and tactical decisions, is key for a sustainable and satisfying portfolio return.
What is the difference between strategic asset allocation and tactical asset allocation?
While implementing an asset allocation approach, clients' goals, liquidity needs, risk-return expectations are incorporated to define an investment goal. A combination of traditional asset classes like equity, bonds and money markets with alternative asset classes like commodities -- to give an example -- is suggested. Strategic asset allocation (SAA) is the long term combination of various asset classes that matches the client's risk profile and long term target. The primary factors driving SAA would be the long-term return drivers for each asset class and the covariance matrix.
Tactical asset allocation (TAA), however, is more dynamic in that it takes into account short medium-term prospects for financial markets. The key factors driving TAA are for example the economic/ business cycle, market implied expectations, technical factors and sentiments. Tactical changes allow the client to be more dynamic especially in extreme times as seen in 2008 rather than having a buy and hold strategy. In various phases of business or economic cycle the attractiveness of various asset classes varies and that is one of the key determinants for tactical calls. As an over-simplified illustration, bonds would be attractive in a typical reflationary environment while stocks would be attractive in economic recovery phase. Academic studies support the view that asset allocation has the greatest impact on returns rather than security selection or market timing.
What would be the benefit of adopting asset allocation for high-net-worth individuals, given that the investment universe of these investors would have equities, bonds, liquidity and alternative investments as main asset classes?
First, not only do these asset classes vary in their risk-return dynamics but also typically with respect to correlation amongst them. At a sub-asset class level, there are numerous options and they too vary from a risk and return perspective. In a well-diversified portfolio, it is possible to reduce risk while maintaining the same level of returns by varying the proportion and number of low correlated asset classes accordingly.
Second, asset allocation in normal times benefits as no asset class performs all the time. Also a diversified portfolio has been found to be relatively safer from an event risk perspective.
Third, asset allocation reduces the dependency on sheer market timing. A sound investment approach for clients is to set an investment strategy and follow it, albeit with tactical changes. Radical changes in strategy regarding the SAA should not take place unless the clients risk profile has altered drastically. There is a value in following the asset allocation approach as timing is an overrated factor of success. Market timing is a risky and difficult business from a pure statistical standpoint. Additionally, investments made with a shorter time frame are by definition riskier.
What is the role of asset allocation post-crisis?
During challenging market conditions, fat tails are considered undesirable because of the additional risk they imply. When data naturally arises from fat tail distribution, the normal distribution model of risk would severely understate true risk.
Correlation between asset classes rose significantly in 2008 with only government bonds providing some diversification benefits. High level of leverage, illiquidity, operational and counter-party risk coupled with lack of transparency lead to elevated correlation especially for the alternative investment asset class with equity market melt-down.
However, 2008 was anything but a normal period and there were structural changes taking place in the financial industry. 2008 crisis was a combination of a globally synchronised recession and financial crisis, thus making it an extremely volatile and chaotic period of reference.
How do you suggest investors approach asset allocation models?
There is a need for more decisive and dynamic asset allocation. The case for a stable buy and hold asset allocation model is weak. This should be combined with various sub-asset class tactical focus to gain more granularity. The target is to achieve the highest inflation-adjusted return per unit of risk. Potentially, the asset allocation approach has been found to be one of the most effective approaches in managing clients' wealth over the long term.