When managing portfolios, do you find yourself using a “target” or “static” asset allocation based on expected returns? You are not alone. But this methodology may not be working as many wealth managers had hoped. Research from Jonathan Xiong, Mellon Capital Management Corp.’s Director and Global Investment Strategist, Global Asset Allocation, indicates that many institutional investors have been disappointed by returns that have fallen short of their “static target or policy asset allocation.”
According to a study released Monday, “Risks of Static Asset Allocation,” for many investors, this has translated into questions about whether Modern Portfolio Theory (MPT) or Mean-Variance Optimization (MVO) are still valid. While it is accepted—confirmed, Xiong says—that asset allocation is the “overwhelming determinant of portfolio returns,” according to the study, he blames “stale market expectations” that “fail to incorporate new information from the market,” for the failure of portfolios to achieve their expected returns.
What to Do?
“Expectations change as a result of new information from the marketplace,” Xiong explains in the study. Rather than “the ‘set it and forget it’ approach,” to asset allocation, he says, “a dynamic asset allocation process allows the investor to react to a dynamic efficient frontier.” He adds: “Investment managers need to dynamically change their asset allocations within a portfolio to reflect the most recent changes in expectations.”
“A fallacy of the static allocation approach is that it assumes return expectations will not change, regardless of capital market or macro economic conditions,” said Xiong in the announcement. “Credit spreads and equity risk premiums can be volatile, and our studies indicate that changes in these factors have affected returns. Our research concludes that a five percent change in expected equity returns has the potential to shift the optimal asset allocation by more than 80 percent.”
Xiong contends that “expected returns are not static” and asserts that “In our view, the main cause of unrealized return expectations has been the adoption of a static target or policy asset allocation by institutional investors. A target or policy asset allocation by definition implies that the set of expectations used to derive the asset allocation mix does not change.”