‘Mindful investing’ and strategic asset allocation

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Suits the C-Suite

Be mindful of where you are headed. This is the Desiderata of the current investing climate, and investors may wish to be reminded of this philosophy. Against a backdrop of increasingly complex business environments, socioeconomic redirection, intensive regulations and disruptive developments, institutions may find it timely to review their investment strategies and asset allocation by conducting a process called Strategic Asset Allocation (SAA).

What is SAA? It is a process whereby investment opportunities and investment vehicles are identified, tested and evaluated, along with the related risks and regulatory requirements. It is a management tool used in establishing the optimal investment portfolio mix and is often conducted simultaneously with asset-liability management and business modelling. It can also be considered a technique for determining the asset mix that optimizes returns, given specific risks taken and general risks faced. It provides a common view for any institution’s boards and management on their current state and allows discussions — from straightforward to spirited — on the direction of their investment strategies. As the risks and regulatory requirements mark the boundaries of the investments, a path is drawn to meet specific investment objectives and mandates. This process of “mindful investing” helps define both the direction and quality of investments that management can take. It answers the question “Where are we headed?”

Typically, the first vital step is to determine the target asset universe — management’s universe of investment opportunities and vehicles or instruments. The granularity of the research entailed to determine such a universe shall depend on the system processing capacity and the desired depth of analysis as set by management. The investment universe could range from familiar assets like bonds, loans and stocks to alternative assets such as property, venture and private equity, to emerging types that have not been understood or embraced by the mainstream financial system. 

Once the investment universe is clear, the next step is an assessment of the potential performance of the investments and the portfolio. This involves the analysis of historical data as well as the integration of market predictions to come up with expected risks and returns of the investment. An option is to include an asset liability management exercise where the institution’s liability profile is matched with the asset universe — a procedure that should be helpful for insurers, pension funds and other asset management companies, and even banks with increasingly long-term and development-oriented business models.

Given these considerations, an “efficient frontier” may be drawn using generalized maximization techniques. Each point of the frontier represents a portfolio with a specific mix of assets together with its returns and risks, taking into consideration the economic and business environment, market challenges and regulatory requirements. In developing the risk-return metrics for each investment or asset class, both the historical and expected returns should be evaluated against the investment objectives, while the risks should take an integrated view, covering at least market, liquidity, credit and operational risks, as well as actuarial and solidarity risks (in the case of insurers and pension funds). At this stage, the process of testing against historical results and constraints can inadvertently constrict opportunities, particularly for investments with long-term horizons. To provide a healthy check of the historical review and risk assessment process, the SAA process should always include an investment mandate review and allow asset reallocation only when the medium-term outlook has significantly changed and there is evidence of investment drift.

The final step involves the SAA tool, which can help provide an asset mix that optimizes the return at the current level of risk, and even as well at the maximum level of risk that the institution may take. The SAA process can run with multiple interdependent iterations as newer sets of information and predictions become available. Fast iterations coupled with heuristic evaluations are now possible, as scientific computing power becomes more accessible and with the fusion of the computational and data requirements. The visualized results are then used in board and management discussions for capital allocation and business modelling decisions, hopefully contributing to clarity in strategy and direction.

SAA is viewed not as a step that may be taken but rather as a necessary step for management to test, distill and clarify its investment objectives and mandates, squarely answering the question “Where are we headed?” But there are nuances that we need to consider given the heightened intensity of sociopolitical disruptions, economic realignments, digital innovations, and market dynamism — “where are we headed” is not the same as “where are we going?”

The level of investing complexity has rapidly moved from the purview of risk and volatility to the region of uncertainty and extreme conditions. There is a limit to what we can clarify from direction and in rediscovering objectives. Perhaps the question that we need to start answering now is “Why are we investing?” and using this rationale as a springboard to evolve from mindful to purposeful investing.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the authors and do not necessarily represent the views of SGV & Co.

Christian Lauron is a Partner and Renz Kristofer Cheng is a Senior Associate, respectively, of SGV & Co.