Posted on Categories Investing

Most of us want to reduce the risk and get a better outcome in our investment portfolio or other areas of life. And, one of the ways to improve investment returns is through asset allocation. Asset allocation is an investment strategy that involves investing in a variety of asset classes to optimise risk and return.

Historical data have shown that the various asset classes, such as equity, fixed income or debt, and gold, indicate a low or negative association. As a result, diversification across asset classes can significantly lower risk while potentially generating higher long-term returns.

There are three main ways to carry out asset allocation: strategic asset allocation, tactical asset allocation and dynamic asset allocation.

Strategic Asset Allocation

If a mutual fund has a static asset allocation mix, then we can say that it follows a strategic asset allocation. The static asset allocation mix is usually in a range, and the fund managers can invest in the investment instruments within that range.

For example, if the asset allocation of a fund mentions that 65-80% of its assets need to be in equity instruments, then the fund manager has to invest 65-80% of the portfolio in equities at all times. In this case, the state of the market and economy doesn’t influence the fund’s asset allocation.

The fund’s asset allocation may change as the price of various investment options such as stocks fluctuates regularly. So, the fund manager may need to rebalance the fund’s portfolio from time to time to maintain the asset allocation breakup of the fund.

Let us consider the previous example where the fund maintains an equity allocation within 65-80% of the portfolio. The fund’s equity allocation may cross the maximum limit if the equity market rises more than the other assets. In this scenario, the equity allocation of the fund may become 90%. So, the fund manager has to sell stocks and/or buy the other asset class instruments such as debt securities to bring the asset allocation back to the intended asset allocation.

Tactical Asset Allocation

You may feel that strategic asset allocation is too rigid. However, market conditions may generate additional returns from time to time that a static asset allocation strategy may be unable to take advantage of. Tactical Asset Allocation is a variation of Strategic Asset Allocation in which the fund managers may deviate a little from the strict asset allocation to take advantage of the market opportunities and earn extra returns for the investors.

To carry out tactical asset allocation, one needs to know market timing and in-depth market and investment knowledge. For instance, if the strategic asset allocation calls for 70% in equity and 30% in debt and the fund manager believes that equities in the short run can provide attractive returns, then they might hike up the equity allocation to 75% to take advantage of the possible upswing in the equity markets. And after the window of opportunity closes, they can revert it to the original asset allocation.

Dynamic Asset Allocation

The counter-cyclical asset allocation method is the most prevalent dynamic asset allocation method implemented by mutual funds. In this asset allocation method, you regularly modify your asset allocation mix based on market conditions. When stock valuations fall, i.e., the stock prices become cheaper, these funds increase their equity allocation and reduce debt allocations. This is also known as a counter-strategy because it is based on the investment principle of buying low and selling high. For dynamic asset allocation, different fund managers utilize different valuation criteria. The most commonly used valuation metrics are the P/E and P/B ratios. In a dynamic asset allocation strategy, some fund managers employ multi-factor asset allocation models, which integrate two or more components, such as P/E, P/B, Dividend Yield, and so on.

Conclusion: There are different asset allocation strategies that investors and fund managers use. Strategic asset allocation, tactical asset allocation and dynamic asset allocation are the three common asset allocation strategies.

This blog is purely for educational purposes and not to be treated as personal advice. Mutual funds are subject to market risks, read all scheme-related documents carefully.

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