What Is Dynamic Asset Allocation?
Dynamic asset allocation is a portfolio management strategy that frequently adjusts the mix of asset classes to suit market conditions. Adjustments usually involve reducing positions in the worst-performing asset classes while adding to positions in the best-performing assets.
- Dynamic asset allocation is a strategy of portfolio diversification in which the mix of financial assets is adjusted based on macro trends, either in the economy, or the stock market.
- The stock and bond components of a portfolio might be adjusted based on the well-being of the economy, the health of a specific sector, or the presence of a broad-based bear or bull market.
- Proponents say this strategy means investors are holding a group of high performers that are diversified enough to manage risk.
- Critics say these actively-managed funds are costlier to run than passive funds and are more labor-intensive.
How Dynamic Asset Allocation Works
The general premise of dynamic asset allocation is to respond to current risks and downturns and take advantage of trends to achieve returns that exceed a targeted benchmark, such as the Standard & Poor’s 500 index (S&P 500). There is typically no target asset mix, as investment managers can adjust portfolio allocations as they see fit. The success of dynamic asset allocation depends on the portfolio manager making good investment decisions at the right time. Dynamic asset allocation is just one portfolio management strategy available to investors.
Dynamic Asset Allocation Example
Suppose global equities enter a six-month bear market. An investment manager using dynamic asset allocation may decide to reduce a portfolio’s equity holdings and increase its fixed-interest assets to reduce risk. For example, if the portfolio was initially equities heavy, the manager may sell some of its equity holdings and purchase bonds. If economic conditions improve, the manager may increase the portfolio’s equity allocation to take advantage of a more bullish outlook for stocks.
Advantages of Dynamic Asset Allocation
- Performance: Investing in the best performing asset classes ensures investors’ portfolios have the highest exposure to momentum and reap returns if the trend continues. Conversely, portfolios that use dynamic asset allocation reduce asset classes that are trending lower to help minimize losses.
- Diversification: Dynamic asset allocation exposes a portfolio to multiple asset classes to help manage risk. Portfolio managers may make investments in equities, fixed interest, mutual funds, index funds, currencies, and derivatives. Top-performing asset classes can help offset underperforming assets if the manager makes a bad call.
Limitations of Dynamic Asset Allocation
- Active Management: Actively adjusting portfolio allocations to meet changing market conditions takes time and resources. Investment managers need to keep up-to-date with breaking macro- and company-specific news to determine its impact on various asset classes. Additional research analysts may need to be hired to help ensure the correct investment decisions are made.
- Transaction Costs: Dynamic asset allocation involves frequently buying and selling different assets. This increases transaction costs that reduce the portfolio’s overall return. If most holdings in the portfolio are trending higher, a management strategy that favors buy-and-hold investing, such as constant-weighted asset allocation, may outperform dynamic asset allocation due to fewer transaction costs.