The Art & Science of Asset Allocation
With 2016 in the rear-view mirror, every investor has surely learned some valuable lessons in how to deal with surprises.
The good news, of course, was that the performance of equities in Q4 became the biggest surprise of all.
Yet even that positive backdrop can present challenges as we head into 2017. That’s precisely why the team at Principal Funds sees an increased need to focus on managing risk moving forward.
“In the wake of a rising market, advisors need to focus on managing the risk associated with rising interest rates and greater volatility,” says Todd Jablonski, chief investment officer and head of asset allocation at Principal Funds, a provider of income-generating ETFs and other institutional quality equity, fixed-income, currency, real estate, and alternative strategies for individual and institutional clients. “As advisors prepare for 2017, leveraging a variety of asset classes and balancing the ‘art and science’ of asset allocation will be the key to uncovering new opportunities while carefully managing new types of risk.”
Multiple asset classes may be a given for many advisors, but combining the ‘art and science’ of asset allocation is a concept that’s just emerging in the ETF space, and one that Jablonski feels may offer a strong advantage as we enter a new era when government policy is expected to impact market performance more than ever before.
“The new Presidential administration is promising huge policy shifts, and with that dramatic change, there are bound to be mistakes that may shock the market,” he says. “And the US isn’t alone. Brexit, global immigration, international relations and conflicts. All of these factors are creating an environment that requires a high level of caution—and one that demands more than a basic, passive investing approach.” That’s where ‘art and science’ must come together.
The conundrum between passive and active management is one that every advisor knows all too well. Each has its pros and cons, but both offer distinct advantages. Combining the two strategies into a single, cohesive approach can help balance a portfolio to survive, or even thrive, in this new reality.
“Passive, cap-weighted investing is based on the idea that collective wisdom tells us everything we need to know moving forward. It’s a science-based approach, but it doesn’t always deliver an advantage—especially when unknowns are in play,” says Jablonski.
His prime example is the fixed income space, where it’s vital to look at factors such as spread and interest rates, and make active decisions to address market changes.
“That level of tactical investing is the ‘art’ side of the equation, and it’s critical for shorter-term investments.”
That said, he stresses that active and passive are best used together to create a strong core portfolio that’s adaptable to change, even when that change is coming in unexpected bursts as we may see throughout 2017.
At Principal, this melding of the two is achieved using a three-step investment process that combines art and science.
Step one uses the numbers to dictate long-term strategic asset allocation that supports the desired level of exposure across multiple asset classes (the “science”). But unlike more traditional, strictly passive approaches, the process doesn’t stop there.
Instead, step two brings art—or tactical asset allocation—into play, rounding out the portfolio by seeking under-appreciated, under-valued assets. Tactical allocation addresses those unknowns that the numbers simply can’t predict or address.
Step three focuses on personalizing the approach to each investor’s specific needs, as well as blending time horizons, taking an active approach to short-horizon investments such as fixed income and bonds (which are almost always retained for the full duration), and a more passive approach to equities which are expected to perform strongly over the long-term.
“The result is a flexible, adaptable ETF with the goal of delivering greater performance and higher yields than traditional ETFs,” he says. “And so far, our Principal EDGE Active Income ETF (YLD) has done just that.”
Jablonski says that he and the team at Principal are less confident in a breakout year than some.
“Many investors we talk to are overestimating returns and underestimating risk in the coming year. That’s a free lunch, and it simply doesn’t exist.” He suggests moving forward with caution by finding that balance between art and science to tilt portfolios toward tactical flexibility built on a strategic core. “It’s an approach that can help advisors and their clients stay steady through the storm,” he says. “Whatever comes our way—be it higher interest rates, policy errors, changing equity fundamentals, or something else completely unexpected—that combination can help make the most of the gains achieved in 2016 by taking steps to lower risk throughout the coming year.”
Principal helps people and companies around the world build, protect, and advance their financial well-being through retirement, insurance, and asset management solutions that fit their lives. The firm’s employees are passionate about helping clients of all income and portfolio sizes achieve their goals—offering innovative ideas, investment expertise, and real-life solutions to make financial progress possible. Learn more at principal.com.
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