What is Dynamic Asset Allocation?
Dynamic asset allocation is a portfolio management strategy that frequently adjusts the composition of asset classes based on market conditions. Adjustments generally consist of reducing positions in the worst performing asset classes while increasing positions in the best performing assets.
Key points to remember
- Dynamic asset allocation is a portfolio diversification strategy in which the composition of financial assets is adjusted according to macroeconomic or stock market trends.
- The stock and bond components of a portfolio can be adjusted based on the well-being of the economy, the health of a specific sector, or the presence of a general bear or bull market.
- Proponents say this strategy means investors hold a group of high-performing companies that are diversified enough to manage risk.
- Critics say these actively managed funds are more expensive to manage than passive funds and are more labor intensive.
How dynamic asset allocation works
The general principle of dynamic asset allocation is to react to current risks and downturns and take advantage of trends to achieve returns above a targeted benchmark, such as the Standard & Poor’s 500 Index (S&P 500 ). There is generally 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’s ability to make the right investment decisions at the right time. Dynamic asset allocation is just one of the portfolio management strategies available to investors.
Example of dynamic asset allocation
Suppose global equities enter a six-month bear market. A portfolio manager using dynamic asset allocation may decide to reduce a portfolio’s equity holdings and increase its fixed rate assets to reduce risk. For example, if the portfolio initially consisted of stocks, the manager may sell some of its equity holdings and buy bonds. If economic conditions improve, the manager may increase the equity allocation of the portfolio to take advantage of a more bullish outlook for equities.
Benefits of dynamic asset allocation
- Performance: Investing in the best performing asset classes ensures investors’ portfolios have the greatest exposure to momentum and reap returns if the trend continues. Conversely, portfolios that use dynamic asset allocation reduce asset classes that tend to decline to help minimize losses.
- Diversification: Dynamic asset allocation exposes a portfolio to multiple asset classes to help manage risk. Portfolio managers can invest in stocks, fixed income securities, mutual funds, index funds, currencies and derivatives. Better performing asset classes can help offset underperforming assets if the manager makes a bad move.
Limits of dynamic asset allocation
- Active management: Actively adjusting portfolio allocations to respond to changing market conditions takes time and resources. Investment managers need to keep abreast of the latest macroeconomic and company-specific news to determine their impact on different asset classes. Additional research analysts may need to be hired to ensure the right investment decisions are made.
- Transaction costs: Dynamic asset allocation frequently involves the buying and selling of different assets. This increases transaction costs which reduce the overall return of the portfolio. If most of the holdings in the portfolio are trending up, a management strategy that favors long-term investing, such as constant-weight asset allocation, may outperform dynamic asset allocation due to reducing transaction costs.