Factors to consider when constructing an asset allocation portfolio

Published: 17th March 2010
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Asset allocation is an excellent way to build long term wealth from a highly diversified portfolio, and allows you to seek risk and return objectives at a reasonable cost. To use this diversification approach, it's beneficial to decide how to structure your portfolio given asset class options. With the abundance of exchange traded funds (ETFs) and index funds, it's fairly easy to build an asset allocation portfolio, but making sure your portfolio has the right mixture of assets is less straightforward. Consider these factors when deciding which asset classes to hold.



An important attribute to consider is that asset classes are nested. For example, equities can be partitioned into US equity, developed international equity and emerging markets equity. US equity can be further partitioned by size, into small cap, mid cap and large cap, making 3 more asset classes. These asset classes could then be partitioned by value and growth, or by sector creating more asset classes. These partitioning attributes such as size and style (growth and value) are known as factors. Professional asset managers use factors to describe asset returns. MSCI Barra uses 68 different factors to explain equity returns. Fixed income asset classes can also be partitioned. For example, bond grade, duration and other metrics can be used to describe bond returns.



One reason to subdividing an asset class into child asset classes is to allocate a different amount of wealth in each of the sub classes than what the parent asset class uses. For example, if you think that growth equities will outperform value equities underweight value. Within an asset allocation model, you would need to split equities by growth and value, and purchase a larger percentage of growth to accomplish this.



Partitioning asset classes also allows you more options by which to diversify your portfolio, pushing the efficient frontier upwards. As an example, if small cap equity becomes uncorrelated with commodities and real estate, and large cap and mid cap do not, then you may want to overweight small cap equities to reduce risk, without giving up return. Balancing your portfolio with uncorrelated asset classes reduces portfolio risk and increases returns-one of the principles underlying efficient portfolio theory. As you can see, there are good reasons for partitioning asset classes to yield more options, but there are also costs.



For a retail investor, using too many asset classes can be costly when trading costs and taxes are considered. Using additional asset classes means more transactions occur, resulting in increased transaction costs and taxes. A balance needs to be struck between management costs and efficiencies gained from partitioning. A portfolio with more asset classes provides greater opportunity to control risk and take advantage of uncorrelated positions, or potential alpha factors, but benefits dimish with the number of partitions, and the cost of management increases.



We've found that 11 asset classes is a suitable number for individual investors looking to maximize diversification benefits, control risk, and keep costs in check. If you're an accredited investor, you may want to position your portfolio to seek broader investments than 11 asset classes. If you do intend to make active market bets you might take a look at the core-satellite framework to structure your portfolio. This framework will help you organize your portfolio into active market bets and your core portfolio, designed to provide diversified market exposure.





For more information about asset allocation, rebalancing and retirement planning please visit our website:

Portfolio Research


Sam Pittman, PhD and Investment Strategist

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