Diversification Weighted Asset Allocation
More Alpha please! Less Beta too ... and a side of asset allocation.
Diversification weighted asset allocation works well with a pre-filter on selection of asset candidates (perhaps based on money manager experience and talent) and then applying true diversification measurement and analysis to determine the optimal blend of those assets that promise the highest returns while simultaneously reducing portfolio risk. (See What is Risk?)
Let's say we can nearly eliminate systematic risk by using the nine-box style-based diversification (ie. capitalization vs. aggressiveness), while going with geo-politial differentiation and asset class selections (bonds, precious metals, stocks, etc.). Great! Now how do we nearly eliminate intra-style-based risk? Using true quantitative diversification weighted asset allocation. In other words, build a portfolio based on the intra-portfolio correlations (IPC) of the assets.
We've found that most portfolios have IPC in the range of 25-35%. True Diversification can deliver between 50% and 60%. This means that after the pre-selection and pre-style risk elimination stages, many portfolios exhibit behaviors that are high in Beta and low in Alpha, because the individual assets move similarly. If you're a market timer this might be fantastic, but few ever time the market well, and that just drives up turn-over and capital gains taxes.
True Diversification is extremely well matched to mutual funds and funds of funds, because these instruments have specific charters, selection and performance criteria predefined.
In fact, by making diversification weighting a policy of such instruments, by setting diversification levels as targets (rather than risk-based allocations), as well as risk or performance (risk-adjusted returns), or industry focus, allocation targets, etc., fund managers will be able to harness their talents and energy where they can add more value, thereby further improving results. This creates a virtuous cycle and improves portfolio (mutual fund) ROI.
Automating much of this process enables re-balancing, retargeting and adjustments to strategy as market conditions change and as individual assets change. Decisions as to what assets to sell or buy become less subjective further eliminating the ‘human element’ and emotions from the virtuous cycle.
Risk is hard to define and measure. Managing risk during the asset allocation stage of portfolio management only decreases performance. Apply risk management up front, then allocate the quality assets optimally.
Because strategies exist to ameliorate risk prior to the allocation stage, utilizing diversification weighted asset allocation makes more sense. Investment policies and allocation practices can be facilitated by the engine of diversification at the portfolio management stage.
Consult your fund managers to find out how they reduce risk and improve diversification with your money.
Diversification weighted asset allocation works well with a pre-filter on selection of asset candidates (perhaps based on money manager experience and talent) and then applying true diversification measurement and analysis to determine the optimal blend of those assets that promise the highest returns while simultaneously reducing portfolio risk. (See What is Risk?)
Let's say we can nearly eliminate systematic risk by using the nine-box style-based diversification (ie. capitalization vs. aggressiveness), while going with geo-politial differentiation and asset class selections (bonds, precious metals, stocks, etc.). Great! Now how do we nearly eliminate intra-style-based risk? Using true quantitative diversification weighted asset allocation. In other words, build a portfolio based on the intra-portfolio correlations (IPC) of the assets.
We've found that most portfolios have IPC in the range of 25-35%. True Diversification can deliver between 50% and 60%. This means that after the pre-selection and pre-style risk elimination stages, many portfolios exhibit behaviors that are high in Beta and low in Alpha, because the individual assets move similarly. If you're a market timer this might be fantastic, but few ever time the market well, and that just drives up turn-over and capital gains taxes.
True Diversification is extremely well matched to mutual funds and funds of funds, because these instruments have specific charters, selection and performance criteria predefined.
In fact, by making diversification weighting a policy of such instruments, by setting diversification levels as targets (rather than risk-based allocations), as well as risk or performance (risk-adjusted returns), or industry focus, allocation targets, etc., fund managers will be able to harness their talents and energy where they can add more value, thereby further improving results. This creates a virtuous cycle and improves portfolio (mutual fund) ROI.
Automating much of this process enables re-balancing, retargeting and adjustments to strategy as market conditions change and as individual assets change. Decisions as to what assets to sell or buy become less subjective further eliminating the ‘human element’ and emotions from the virtuous cycle.
Risk is hard to define and measure. Managing risk during the asset allocation stage of portfolio management only decreases performance. Apply risk management up front, then allocate the quality assets optimally.
Because strategies exist to ameliorate risk prior to the allocation stage, utilizing diversification weighted asset allocation makes more sense. Investment policies and allocation practices can be facilitated by the engine of diversification at the portfolio management stage.
Consult your fund managers to find out how they reduce risk and improve diversification with your money.
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