As more transparent and accurate information becomes available, traditional economic data could be confirmed or augmented with better conviction. For example, data items such as satellite images or surveys provide more real-time snapshots of manufacturing or consumer activities. These data items could be analyzed to gauge overall sentiment or to identify trends. In fact, they have already made an impact in helping certain corporations increase productivity and streamline capital deployment.
Some of these data also have made their ways into security selection processes. It is highly likely that more accurate and real-time information, by providing clearer pictures of market environment, would enable investors to make strategic yet more targeted and nuanced asset allocation assessments. More importantly, these more refined allocations would help reduce correlations among allocated asset classes, thus lowering the overall volatility of the investment strategy.
For instance, rather than allocating broadly to the emerging markets region, allocation could be made targeting more growth-oriented yet environmentally friendly and socially responsible emerging markets assets excluding specific countries. We believe this more precise allocation not only enhances the diversification characteristics, but also helps extract more compelling performances.
Of course no allocation work is complete without implementation. In fact, implementation is crucial for fully realizing asset allocation benefits. Especially with a more targeted allocation, highly customizable investment solutions are essential to accommodate more polished market views. This process not only should solve for best blend of various instruments from return and risk perspectives, but also should be efficient in reducing unnecessary costs and taxes.
With the proliferation of exchange-traded funds covering various segments of markets, constructing a portfolio of ETFs could be a good way to put asset allocation views in action.
When selecting appropriate ETFs, to make strategy feasible, fees and tracking errors to the desired market exposures need to be carefully examined. Out of more than 1,200 ETFs in the U.S. we studied, average management fees vary from close to zero to $1.35 with the average around 46 cents. Typically, fees for ETFs tracking specific segments of markets tend to be higher than those tracking a broad-markets index. Tracking errors to respective indexes also cover a wide spectrum, ranging from 20 basis points to well over 5% .
If no satisfactory ETFs are available for the desired market segments, or a more active approach is favored, one could certainly construct portfolios using underlying securities to obtain preferred allocations in a more exact manner. This should allow more latitude in building a portfolio as well as reducing management fee payment.
In all likelihood, a sophisticated portfolio construction process is needed to ensure the final implemented portfolio is an optimal blend of ETFs and/or underlying securities to best capture the efficiencies of ETFs and flexibilities of underlying securities.
Regardless of the portfolio composition, there are other costs associated with execution, such as custodian fees, transaction costs and taxes. As views on various asset classes adapt to developments in the markets, the portfolio should be reasonably liquid to ease transactional costs, and turnovers during rebalancing should be managed in a most tax-efficient way. In other words — a nimble implementation process is vital to make the targeted allocation feasible.
In addition, often times each asset allocation decision comes with certain set of constraints, such as tolerance of tracking errors, position limits, beta or volatility limits. The final portfolio needs to follow these constraints judiciously. If there are conflicts between the asset allocation decisions and the constraints, the best way to resolve them would be through direct discussions between asset allocators and implementers. Using the aforementioned emerging markets example, although the allocation is to emerging market growth stocks, there might be strategy limits to overall volatility or valuation style measures that simply replicating market indexes would not adhere to. In that case, scenario analysis would be a very helpful tool in arriving at a mutually satisfactory solution.
With growing globalization and technology development, asset allocation will become more sophisticated, timely and more idiosyncratic in nature. In order to best maximize the asset allocation decisions, these advancements call for more highly customizable and flexible portfolio construction processes, as well as expertise to generate the most optimal blend of securities tailored to each individual case.
