Asset Allocation Explained
Asset allocation is the primary driver of risks and returns. Every investor – knowingly or not – makes asset allocation decisions. People are changing their asset allocations when they make deposits into their savings account, buy a home, or invest in the latest IPO. Others are more active and systematic; for example, they make monthly contributions to their investment funds. Even though some of these activities may seem routine, how you divide your capital among the major asset classes – cash, stocks, bonds and real estate – will likely have a big impact on your portfolio’s returns.
In fact, there is research showing that more than 93% of a portfolio’s returns can be explained by the mix of the broad asset classes in the portfolio1. The asset classes that you choose, plus how much you invest in each of these asset classes, will influence both the risks and returns generated by your portfolio.
Why diversify across asset classes? The shorthand for diversification is: don’t put all your eggs into one basket. Diversification is a technique for managing investment risk, and when you diversify, you spread your funds across different asset classes rather than putting all of it into, say, the U.S. stock market. While it is often considered “the only free lunch in investing,” diversification is not a guarantee of positive returns. That said, diversification can help lower your overall investment risk.
This table shows the annual returns of seven major asset classes between 2007 to 2016. The best performing asset class in one year was rarely the winner the following year. But as long as the different asset classes don’t always move in the same direction, and make gains on average over the long run, they can effectively diversify a portfolio.
Why investors should factor investment fees. Since the selection and weights of the respective asset classes in a diversified asset allocation model are the primary drivers of risk and return, it is important to tightly control the investment management fees that you pay. Several studies have shown that a fund’s expense ratio is one of the most important factors in its long-term performance relative to its peers2. This relationship has created a growing demand for low-cost index investing vehicles. Implementing a cost-conscientious asset allocation model using no fee and low fee investments helps limit the adverse impact of fees on your portfolio’s long-term performance.
Major Asset Classes
The United States is the world’s largest and most developed economy with a highly liquid stock market. It generates more than 20% of the world’s nominal GDP and represents about 40% of the world’s stock market value. The U.S. Equities asset class provides exposure to the companies that are listed and traded on U.S. stock exchanges. An allocation to U.S. Equities seeks to provide investors with a source of long-term capital appreciation as well as inflation protection.
Developed Markets Stocks
The global nature of businesses today, make for a strong case for allocating portfolio funds to non-U.S. stocks – specifically mature economies. An allocation to the Developed Markets Stocks asset class provides exposure to companies based in industrialized economies such as Japan, United Kingdom, and Germany. While similar to U.S. businesses in their maturity level, development practices, and expected long-term growth rates, the companies based in these countries are also shaped by their country’s or region’s unique demographics, fiscal and monetary policy, and currency movements.
Emerging Markets Stocks
An allocation to Emerging Markets Stocks seeks to provide investors with the opportunity to participate in rising markets like China, India, and Mexico that are likely to grow faster than developed economies. As faster economic growth often leads to stronger earnings growth, this may in turn lead to higher returns for the businesses based in these countries. If you want to chase these returns, be prepared to take on additional risks that are often associated with emerging markets investing that include currency volatility, political instability, lax corporate governance, and lack of liquidity.
The United States has the world’s largest bond market with debt issued by federal, state and local governments as well as agencies and corporations that are used to fund their operations. Historically, U.S. government bonds have shown lower volatility than equities while corporate bonds can offer opportunities for higher yields to compensate for their credit risk and liquidity profile. An allocation to U.S. Bonds seeks to provide investors with a low-risk, diversified, and steady income stream.
The global bond market has grown significantly over the past few decades with a value of nearly 1.5 times that of the U.S. bond market. The International Bonds asset class consists primarily of debt issued by governments, non-government organizations, and corporations based outside of the U.S. International bonds have historically offered higher yields than U.S. bonds due to their credit risk profile in connection with a series of defaults occurring between the 1980s and 2000s. An allocation to International Bonds seeks to provide investors with income and capital appreciation opportunities along with diversification benefits.
Commodities reflect the prices of natural resources. Examples of natural resources include energy (e.g., oil, natural gas), industrial metals (e.g., aluminum, copper), precious metals (e.g., gold, silver), and agricultural products (e.g., soybeans, cotton). Commodities can serve as a vehicle for inflation protection as raw commodity prices are used to calculate the U.S. Consumer Price Index (CPI). Because commodities have had a low correlation to other asset classes historically, they can be help diversify a portfolio. Commodity related companies are typically more volatile than the broader U.S. equity stock market. In addition to typical business risks such as operation of a mine or manufacturing plant, commodity companies are also exposed to the underlying price of agricultural products such as wheat and soybean, and energy related products such as oil and natural gas, which tend to fluctuate with global macroeconomic activity, supply and demand dynamics, and the U.S. dollar (as commodities are priced in U.S. dollar).
Real Estate refers to U.S. real estate investment trusts (REITs) that own, operate and manage residential and commercial properties across the country. REITs are required to distribute the majority of their earnings to shareholders and therefore can generate high dividend yields, which can in turn deliver income streams for investors. Given that rents and property values move in line with economic growth, REITs can help provide investors with inflation protection while offering the potential for long-term capital appreciation. Distributions from REITs can be derived from both rental income and non-rental income sources such as sale of investment property, interest income and use of leverage, which could be less stable than rental income. REITs’ historical low correlation to other asset classes can be used to achieve greater diversification at the portfolio level. Real estate companies are typically more volatile than the broader U.S. equity stock market. Potential risks include higher leverage and stock price fluctuations related to interest rates.
Investing in Asset Classes through Motifs
Motif’s vs. individual mutual funds and ETFs
Motifs can offer a unique and transparent way of gaining exposure to the underlying asset classes in a diversified asset allocation vehicle. Unlike mutual funds and exchange-traded funds (ETFs) when you invest in a motif, you actually buy and own the underlying shares of each stock within it. (fixed income-based motifs contain a collection of individual ETFs.)
This means that if you own a motif, you always know exactly which individual exchange-listed securities you own, and you can adjust and trade them however you like.
Owning individual securities may also allow investors to reduce income tax liabilities by strategically timing capital gains—such as by taking short-term losses during high-income years and deferring long-term gains to lower-income years.
How we built our asset allocation motifs
We make available Motif Impact Portfolios, a collection of seven asset class motifs. Each equity motif represents an asset class comprised of individual securities and American Depositary Receipts (ADRs) listed on U.S. exchanges.
- U.S. Stocks
- Developed Markets Stocks
- Emerging Markets Stocks
- Real Estate Stocks
- Commodities Stocks
Building in diversification to mitigate risks
Investors have to be exposed to some degree of risk in order to reap reward, and market risk is the one risk that no investor can escape. That is, every security is subject to factors that influence the overall direction of the market. However, we try to neutralize other sources of risks of the motif’s underlying stocks and ADRs. This is done by first identifying the key sources of risk that can be mitigated through diversification, and these include company risk, sector risk, and country risk. We then construct the motif by assigning a weight to each security across these risk sources.
Example 1: U.S. Stocks motif
One way to get the broadest possible exposure to U.S. Stocks is to hold the stock of every company whose primary geographical exposure is to the United States and weight their allocation by the company’s market value. But since a portfolio or motif holds a limited number of securities, we need to replicate this broad exposure which requires us to first identify the primary sources of diversifiable risk.
For U.S. Stocks, the risks that can be managed through diversification are industry risk and company-specific risk. Therefore, to provide broad exposure to U.S. Stocks requires spreading the weight of the motif both across stocks and sectors. Here are the key steps used to construct the U.S. Stocks motif:
- Identify all U.S.-listed stocks of companies whose primary country of risk (based on management location, primary exchange listing, revenue and reporting currency) is the United States while screening out newly issued stocks (our methodology requires more than three months of trading history), as well as companies that fail to meet liquidity criteria (our methodology requires $1 mm average daily value traded).
- Calculate the sector weights of the broad U.S. Equities universe (e.g., 23% for Technology, 21% for Financials).
- Based on the sector weights, determine both the target number of companies from each sector and the target weight for each sector in the motif (e.g., a 23% weight for Technology in the broad U.S. Equity universe implies a target weight of 23% for Technology stocks in the motif and approximately 23% of stocks would be selected from the Technology sector).
- For each sector, select stocks starting with those having the highest total market value.
- Lastly, weight the selected companies in each sector by their respective market capitalization, then scaled their allocations proportionately to achieve the sector’s target weight in the motif.
The result? Here are the composition and weightings for the U.S. Stocks motif:
U.S. Bonds and International Bonds motifs are constructed using exchange-traded funds (ETFs) to implement exposure to the two underlying asset classes. For both asset classes, the major types of fixed income issues were identified and utilized to allow for broad exposure; these include municipal, corporate, agency, and treasury bonds. Then, within each type, ETFs were selected based on objective parameters such as expense ratios (i.e., management fees charged by the ETF), liquidity metrics (i.e., how easily the fund can be bought or sold), assets under management, holdings, and credit ratings (i.e., an evaluation of the fund’s credit worthiness by independent rating agencies).
Investment horizon and risk tolerance: how they shape asset allocation decisions
No matter what your investing time horizon is, the returns on any asset class is an uncertainty. But if you’re willing to bear this uncertainty, you would expect to be compensated. The reward for bearing risk, or the risk premium, is determined by the participation of investors in the marketplace as they arrive with different time horizons, risk aversions, and techniques for evaluating an investment. Since the collective behavior of market participants should remain constant over the long-term, we don’t expect changes to the risk-reward relationships of long-term bonds beating short-term bond yields and of equities beating bond’s expected returns.
As shown in the table below, risk is generally higher for equities, real estate, and commodities (the riskier asset classes) than bonds (less risky asset classes), as measured by the standard deviation of asset class returns annual volatility, which is represented by the standard deviation of returns for each respective asset class. Standard deviation is a measure of dispersion of a set of data from its mean. Standard deviation is calculated as the square root of variance by determining the variation between each data point relative to the mean. Correlation is a measure of the relationship between the returns of two asset classes. High correlation near 1 means if one asset class moves in one direction, then the other asset class also moves in the same direction, in lockstep. Conversely, low correlation near -1 means if one asset class moves in one direction, then the other asset class moves in the opposite direction. Lastly, a correlation near 0 means that there is little relationship between the two asset classes3.
The longer your investment horizon, the more likely you are to accept the risk of asset allocations that tilt towards riskier asset classes. Consider the case of young investors who bear greater risk of having their purchasing power eroded by inflation because of their longer time horizon. The flip side is they can also make up for any short-term market setbacks through income earned over their many remaining years of employment. This is captured in the Motif Impact Portfolios which reflects the systematic move away from perceived riskier asset classes to traditionally less risky asset classes as investors near their investment horizon.
While investors with longer investment horizons may have more time to recover from any losses, they also have more time to experience them. The notion of risk tolerance attempts to model investors’ willingness – reflecting both their emotional and financial ability — to bear the risk that comes with seeking portfolio returns. For a given time horizon, the table below shows how asset allocations could vary for three simple levels of risk tolerance: low, medium, and high. As one would expect, a move from a high to medium to low risk tolerance level within the Motif Impact Portfolios is associated with an allocation away from typically riskier asset classes toward less risky asset classes as shown below.
Expressing Values in your Asset Allocation
Integrating Investor Values using MSCI ESG Ratings
From environmental sustainability to fair labor management and good corporate behavior, investors increasingly want their portfolio to be aligned with their values and beliefs. What’s unique about the Motif Impact Portfolios is that it not only incorporates investors’ investment horizon and risk tolerance but also attempts to align the portfolio with their values.
Motif utilizes the ESG (Environmental, Social, and Corporate Governance) Ratings data provided by MSCI ESG Research ratings in our Motif Impact Models to allow you to choose your investments based on your values. MSCI collects data from a wide range of academic, government, NGO, and corporate sources to assess a company’s exposure to environmental, social, and governance issues and how well it manages them as a corporate citizen.
Below are three popular value-investing themes that investors can choose through the Motif Impact Portfolios.
Motif scores each company’s contribution to supporting a sustainable planet using MSCI scores on two key issues: Carbon Emissions and Product Carbon Footprint.
- MSCI’s carbon emissions scores are based on a company’s exposure to greenhouse gas intensive practices and emerging regulations; carbon reduction targets and mitigation programs; and the intensity of carbon emissions over time compared to their peers.
- MSCI’s Product Carbon Footprint scores are based on a company’s reliance on carbon intensive products and efforts to measure and reduce the carbon footprint of their supply chains. Companies with favorable scores on these two key issues are tagged for inclusion in the motifs aligned with the Sustainable Planet value.
Note: for real estate firms, Motif uses MSCI’s score on Opportunities in Green Buildings as the stand-in for the Sustainable Planet value. The MSCI score on this issue evaluates the extent to which companies take advantage of opportunities to develop or refurbish buildings with lower energy inputs, recycled and health-friendly materials, lower water use, and waste reduction.
Motif scores how well companies treat their employees using MSCI scores on three key issues: Labor Management, Health and Safety, and Supply Chain Labor Standards. MSCI’s Labor Management scores are based on exposure to regions facing labor unrest, size of workforce, and corporate restructuring and layoffs; workforce policies, benefits, training, and employee engagement; and labor-related controversies.
MSCI’s Health & Safety scores are based on firm’s exposure to businesses and geographies facing high accident rates; health & safety targets and oversight; and accident rates and fatalities over time and their performance in these areas compared to that of their peers. MSCI’s Supply Chain Labor Standards scores are based on brand visibility and reliance on outsourced production; labor policies, compliance monitoring, and engagement with suppliers; and labor controversies in the supply chain.
Companies with favorable scores on these three key issues are tagged for inclusion in the motifs aligned with the Fair labor value.
Good Corporate Behavior
Motif scores companies for good corporate behavior using MSCI scores on three key issues:
- Business Ethics and Fraud. MSCI’s score on this issue evaluates the extent to which companies may face regulatory or legal risks or loss of investor confidence due to fraud, executive misconduct, insider trading or other ethical lapses.
- Corruption and Instability. MSCI’s score on this issue evaluates the extent to which companies may face regulatory risks or lost market access due to corruption scandals or political and social instability. MSCI’s scores are based on reliance on government contracts and operations in regions facing political instability or high perceived corruption levels; anti-bribery policies, programs, and transparency; and controversies.
- Financial System Instability. MSCI’s score for this issue is particularly relevant for financial services firms, is based on size, interconnectedness, and complexity; risk oversight, governance, and commitments to ethical standards.
Companies with favorable scores on these three key issues are tagged for inclusion in the motifs aligned with the Good Corporate Behavior value.
Expressing your values systematically in the Motif Impact Models
To understand how ESG values are incorporated into the Motif Impact Models, let’s take the example of two investors with identical investment horizons and risk tolerance levels. The first is a “climate-change-conscious” investor who wants his or her portfolio to express the Sustainable Planet value; the second is a “default” investor who is neutral on the three values and chooses the default Motif Impact Portfolios.
Both investors would start with an asset allocation determined by their risk tolerance and investment horizon. For the “default” investor, each asset class will be implemented and expressed through the default asset class motifs – motifs of individual securities for five asset classes and motifs comprised of ETFs for the fixed income asset classes.
The “climate-change-conscious” investor would express his or her asset allocation in the Motif Impact Model for five asset classes – U.S. Stocks, Developed Markets Stocks, Emerging Markets Stocks, Real Estate Stocks, and Commodities Stocks – using the Sustainable Planet versions of the default motifs. The Sustainable Planet version of an asset class motif differs from the default asset class motif in that stocks with poor “Sustainable Planet” scores are systematically replaced with those with good scores while maintaining the allocation across sectors and countries. The methodology is designed to express the investor’s value without compromising on the motif’s exposure to the risk factors that typically drive portfolio returns.
All motifs in the Motif Impact Portfolios are updated quarterly using consistent systematic methodology to allow investors in these portfolios the opportunity to maintain their exposure to the underlying asset classes. Each of the values-aligned motifs are also updated each quarter to incorporate current ESG Ratings data provided by MSCI ESG Research.
Additionally, as investors get closer to their investment horizon, the underlying asset allocation of the investor’s Motif Impact Portfolio is rebalanced annually to shift away from perceived riskier asset classes and shift toward traditionally less risky asset classes. As part of the Motif Impact subscription, portfolios are automatically rebalanced by Motif for the investor, for updated holdings within each portfolio, as well as asset allocation weighting.
1P. Brinson, L. R. Hood, and G. L. Beebower, “Determinants of Portfolio Performance”, Financial Analysts Journal (1986)
2Philips, Christopher B., Francis M. Kinniry Jr., Todd Schlanger, and Joshua M. Hirt, “The Case for Index Fund Investing”, Valley Forge, Pa.: The Vanguard Group (2014).
3 Investopedia www.investopedia.com
Investing in securities involves risks, you should be aware of prior to making an investment decision, including the possible loss of principal. An investment in individual stocks, or a collection of stocks focused on a particular theme or idea, such as a motif, may be subject to increased risk of price fluctuation over more diversified holdings due to adverse developments which can affect a particular industry or sector. Investments in ETFs can include those with a narrow or targeted investment strategy and can be subject to similar sector risks than more broadly diversified investments.
The presentation of Motif Impact Porfolios does not constitute a recommendation for a particular investment or investment strategy. Motif Impact Portfolios are presented as a starting point for investors to consider. Motif makes no representation regarding the suitability of a particular investment or investment strategy. Investors are responsible for all investment decisions they make including understanding the risks involved with their investment strategy.
©2017 Motif Investing, Inc. (Member SIPC).