Investment Styles

Asset allocation

Asset Allocation is the process of determining optimal allocations for the broad categories of assets (for example, stocks, bonds, Cash,...) that suit your investment time horizon and risk tolerance.

While this process can be performed on any portfolio with two or more assets, it is most commonly applied to asset classes. This allocation is probably the most important decision and may account for more than 80 % of the return of the portfolio.

Each asset class will generally have different levels of return and risk. They also behave differently. At the time one asset is increasing in value, another may be decreasing or not increasing as much and vice versa. The measure used for this phenomenon is called the correlation coefficient.

The portfolio theory was originated by Markowitz in the early 1950's. and further developed in the 1960's by Sharpe.

Based on the principle "Don't put all your eggs in one basket.", the investors knew intuitively that it was smart to diversify their portfolios. Markowitz was the first to quantify risk and demonstrate quantitatively why and how portfolio diversification works to reduce risk and optimize return for investors.

Markowitz has also introduced the concept of an "efficient portfolio". An efficient portfolio is one which has the smallest attainable portfolio risk for a given level of expected return (or the largest expected return for a given level of risk). The theory of Markowitz, known as CAPM (Capital Asset Pricing Model).

There are two types of asset allocation, fixed (or traditional) and dynamic.

Fixed asset allocation uses a fixed ratio to distribute assets among different investment categories. The ratio is typically determined using parameters such as an investor's age, financial objectives or risk tolerance. While this approach reduces risk, it does not take advantage of market conditions and leaves significant portions of the portfolio vulnerable to market downturns. The more categories used to diversify risk, the more return tends to be reduced compared to the best performing segments of the market.

Dynamic asset allocation, also called tactical asset allocation, is an active investment approach that distributes assets among the different assets classes in domestic and international equity and bonds investments and money markets. That distribution is adjusted on a continuing basis in response to market and economic conditions, based on the advisor's perception of the return potential and relative risk of each asset class.

Dynamic asset allocation, like a "fixed" asset allocation strategy, seeks to reduce risk through diversification among different investment categories. Using dynamic asset allocation, however, investors select or weight investments based on those categories with the greatest perceived potential for superior returns, given current market conditions. The allocation of assets becomes dynamic - changing in response to market conditions and perceived opportunities for profit.

Why has dynamic asset allocation worked? The financial markets tend to move in cycles. Over a century of market history has clearly shown that dissimilar investment categories behave differently at different times in the economic cycle. The dynamic asset allocator uses technical and/or fundamental analysis to identify where the market is in a cycle and what investment categories appear to have the strongest potential for appreciation.

The objective to dynamic asset allocation is to reduce risk by a greater amount than return is sacrificed and achieve real growth after taxes and inflation. Eliminating risk from a portfolio is very easy. All one has to do is buy Treasury bills. But the lower risk comes with lower returns. Dynamic asset allocation is a strategy for managing risk without unduly diminishing returns and it works well with mutual funs. Using mutual funds in a dynamic asset allocation strategy further reduces risk by providing instant diversification across hundreds of securities within each asset class and allowing investors to move assets overnight between funds with little or no cost.

Market timing is an investment strategy designed to reduce the risk of investing in the stock market and improve the opportunity for investment returns. Its principle objective is to preserve capital by avoiding major market price declines and position client assets in the asset class most likely to excel in rising markets.

Typically market timing is differentiated from active forms of asset allocation by the investment manager's willingness to make 100% moves between asset classes. Pure market timers use technical analysis to determine when to make moves completely in or completely out of specific asset classes. In most cases, these asset classes include US stocks, money market funds and bonds.

Most market timers use mutual funds to implement their strategies, moving investments between industry sectors and among various types of equity, fixed-income, and money market funds, in both domestic and international arenas. Increasingly, timers are moving to use index-based, exchange-traded securities developed specifically to facilitate active management. These investments include "bull" and "bear" funds designed to correlate with the major indices as well as SPDRs, WEBs, Diamonds and more.

Market timing is founded upon the belief that market events are not random and that discoverable relationships exist between different data and the performance of financial markets. Using computers, professional market timers have developed timing strategies that take advantage of these relationships. These strategies look for long-term trends in the market's fluctuations to detect periods of sustained up or down movements. During an up leg of the market, investments are put into equities to maximize return. When the market appears to have hit a top, investments are moved into cash or bond positions until the next up market.

Market timing involves moving in and out of the market in response to indicators typically generated by mathematical models. These models attempt to identify either the current trend of the market or the possibility of a change in that trend. Studies of actual results of professional money managers using market timing techniques reveal that the average timer's results, like the average mutual fund, slightly lag market indexes. At the same time, there are a growing number of timers who consistently outperform the market over a full market cycle - both bull and bear. When risk-adjusted return is used as the way to measure performance, even the average market timer outperforms the market by a notable margin (Wagner, Shellans and Paul, 1992; Hulbert, 1993; Chance 1998).

Critics of market timing often point out that it is impossible to accurately predict market tops and bottoms. While this is true to date, a market timer does not have to be perfect in discerning entry and exit points in the market. Successfully avoiding a significant portion of a decline results in extra dollars and leverage for the timer. The active investor needs to capture only a portion of the next market advance to stay even with or exceed the returns of the buy-and-hold investor.

Fund Timing

While market timing tends to focus on the macro aspects of the market, fund timing looks at the specific performance of an individual fund in the context of the market and fund category. Moves are made between equity, bond and money market positions in a mutual fund family or variable annuity or between investment options offered through a fund distributor, such as a trust company or brokerage firm. Mutual funds offer a number of advantages, including professional stock selection, diversification, defined investment objectives and convenience.

The objective of stock fund timing is to reduce risk or fluctuation in an investment account's value while achieving higher returns than other investments with similar risk. It does so by seeking to avoid declining markets and preserve capital so that one has more to invest during rising markets.

Sector Timing

Investing in the right industry group, or sector, of the market at the right time can dramatically increase returns. Sector funds are mutual funds that are invested in a diversified list of securities, but all in one specific industry group, such as energy, transportation or utilities. There are also country-specific sector funds with investments in one country or region, like Japan or Latin America. Although less than 5% of the total number of mutual funds are considered true sector funds, in bull and bear markets, 40% or more of the top performing funds have been sector funds. (MorningStar Mutual Fund data)

A buy-and-hold strategy for sector investing is typically a recipe for disaster, because no one sector remains continually in favor. In 1998, for example, Fidelity's Select Energy Services fund dropped -49.7% while Select Computers gained 94.4%. While the gains are easy to take, few investors have the fortitude to sit through 50% losses in a single year.

The volatility and potential of sector funds results from three key factors:

Rotation - if you look at sector funds over a period of time, it quickly becomes apparent that above-market returns one year may be canceled out by a loss in the subsequent year.

Pure play - because stocks within each sector typically move in unison, these funds offer a pure investment play within the sector. In sector funds, the tendency for the majority of stocks to move together is magnified.

Focus - a portfolio manager who is focused on a few sectors can better understand each sector and better target stocks with the greatest potential for growth within the group.

Because sector investing must be approached on a disciplined, non-emotional basis, investors need to have confidence in their strategy. The only way this can be achieved is through back testing and real-time application on a controlled basis. One tool for sector selection is the relative strength approach. This technique measures the performance of one sector in terms of how strong or weak it is by comparison to all other sectors and market indices over certain periods of time.