And one of the outcomes of effective asset allocation is the ‘Risk Rebate’, which allows them to increase exposure to growth assets without exceeding the fund’s overall risk budget.
The Risk Rebate can be illustrated by this example. XYZ Fund invested in three assets when it was first launched. Assets 1 and 2 are primarily growth assets and carry relatively high levels of risk.
It also invested in Asset 3, which is more defensive and carries less risk. If we add the 3 assets’ risk levels together, we see the ‘sum of the parts’ (ie, total gross risk). But because diversification reduces overall risk, we can stay within the stated risk profile for the fund.
Recently, XYZ Fund’s asset allocation team conducted a full optimisation review. They could not increase the overall risk budget, nor increase the charges to customers, but they could broaden and change the assets the fund invests in. They opted for a broader asset mix.
The Fund’s asset allocation team were able to take advantage of a much bigger Risk Rebate when planning and calculating the new optimal asset mix.
Because they knew they were broadening and improving the diversification, they could increase allocations to riskier assets and ultimately offer customers more exposure to growth assets without raising investment risk – which in turn could lead to better returns over the longer term.
Putting the risk rebate to work
This theory may sound straightforward, but putting it into practice requires significant expertise, analysis, and modelling capability.
Any additional asset classes need to be examined in isolation to determine their risk and reward characteristics, and then any proposed blends of assets must be rigorously tested and refined.
This process – and the resulting asset allocation – takes careful account of levels of correlation and how assets perform in different conditions.
Lastly, but vitally, any optimisation needs to take into account the cost of accessing each asset class, noting that some asset classes are more expensive than others.
Optimisation reviews and increasing diversification is increasingly important. As market environments change, broader diversification plays a crucial role in planning and calculating any optimal blends of assets.
It is founded on the simple logic that is at the heart of diversification, but in the hands of asset allocation experts, it is a key technique for increasing potential returns for your customers.
For the latest insight, case studies and expert guidance on multi-asset investing, visit www.scottishwidows.co.uk/multi-asset
Iain McGowan is director, investments, for Scottish Widows
