Contemporary Strategic Asset Allocation

Strategic Asset Allocation: How to Think About Real Estate in Portfolio Allocation

Strategic asset allocation is the practice of holding a defined portfolio allocation – with respect to asset classes – over a sustained period of time to achieve a given investor’s goals, tailored to their specific risk tolerance, investing time horizon, and return objectives.

We’ve discussed the practice of asset allocation that mirrors institutional investors like the Yale Endowment, who have experienced sustained success through business cycles. In particular, successful institutional investors typically allocate a significant portion of their portfolio to private-market alternative assets, like real estate. With the advent of platforms (like EquityMultiple) that allow for fractional investment in private real estate, individual investors can achieve similar portfolio allocation – diversifying into historically-inaccessible assets and achieving lower inter-asset correlation among the assets in their portfolio. As discussed in prior articles, this amounts to practicing Modern Portfolio Theory at a smaller scale.

Strategic Asset Allocation is a related practice that entails thoughtful allocation, regular rebalancing in accordance with realized returns on assets, and a deliberate (if infrequent) refactoring of allocation targets to align with shifting return targets and risk tolerance. Like Modern Portfolio Theory, Strategic Asset Allocation is a concept for all individual investors to keep in mind and, like MPT, it is a practice that bears reconsidering in light of new platform-based investing options now accessible to individual investors. This article takes a look at contemporary considerations in Strategic Asset Allocation.

Setting Asset Allocation Targets in the Modern Investing Landscape   

This old bromide stipulates that at any particular age, you should hold 100 – (Your Age in Years) % in the stock market, and the balance in bonds. We’re not sure the “100-minus-your-age” rule should ever have been given too much credence (and we’re not alone). The basic premise of this simple rule does hold water: as you get older and closer to retirement, you should hold less risk in your portfolio, reducing the percent held in public equities markets where volatility could hurt you at the wrong moment. And, your target asset allocation should be refactored as you grow older. However, there are several limitations to this thinking, particularly now:

• Individual investors have a broader array of options: The 100-minus-your-age rule presupposes that the investor has a binary choice between stocks (high upside, high risk) and bonds (low upside, low risk). Now more than ever, there is a spectrum of risk/return profiles across a broadening spectrum of asset classes available to individual investors. For example, equity crowdfunding (investing as a ‘micro-VC’ in pre-IPO startups) carries the kind of upside that even small-cap stocks can’t offer, but also a tremendous amount of risk. Young, risk-tolerant investors may credibly consider adding a limited degree of this asset class. On the other hand, investments in private commercial debt secured by real estate (such as are offered by EquityMultiple) can provide target fixed-rate returns that well-exceed the typical range of returns for bonds, T-Bills, or other fixed-rate vehicles.
• Diversification is King: This broader array of risk/return profiles can help investors find a strategic asset allocation that better aligns with long-term goals. It also presents greater opportunity to de-correlate among assets within the portfolio, better positioning the investor to weather market swings.  
• Times Change: Investing philosophy and objectives may change throughout one’s lifetime. This alone may be an issue with traditional strategic asset allocation. As technology disrupts traditional investing paradigms, creating new options and shifting our calculus, it’s clear that investors must remain adaptive, even if their long-term goals are conventional.

Strategic Asset Allocation vs. Tactical Asset Allocation

Tactical vs. strategic asset allocation used to come down to “are you a day trader or not?”. Tactical asset allocation refers to moving assets frequently, often on a minute-by-minute basis to capitalize on micro-swings in markets. Of course this takes time and, to an increasing extent, vast technological capabilities. And, even with vast resources, hedge funds and other sophisticated investors don’t always outperform a basket of index funds.

Most individual investors are better off with an approach closer to strategic asset allocation: establishing a long-term plan in accordance with goals, rebalancing occasionally, and sticking with their strategy through business cycles and market swings that even advanced machine learning cannot predict. However, as private market alternatives become more accessible and more attractive for many individual investors, some degree of flexibility is warranted; strict adherence to strategic asset allocation should not be adhered to at the expense of diversifying into private-market alternative assets which can reduce a portfolio’s exposure to systemic risk and provide new opportunities for alpha.

Rebalancing in the Modern Investing Landscape  

A key component of strategic asset allocation is rebalancing in order to maintain target allocation proportions as the assets in your portfolio yield differing returns over time. Let’s look at a simple numeric example:

• Your strategic asset allocation is 70% stocks and 30% bonds,
• You are rebalancing on an annual schedule
• In Year X, your stock portfolio yields a 10% annualized return, and your bond portfolio yields a 5% annual interest

Following Year X, the better yield of the stock portfolio means this investor now has 71% of her portfolio in stocks. She must sell 1% of her portfolio and re-allocate to bonds in order to maintain her strategic asset allocation of 70% stocks, 30% bonds.

This rebalancing exercise becomes much more complicated with new asset classes added to the mix. We’ve discussed at length how illiquid assets like private real estate can provide returns that are uncorrelated from public equities markets, and can provide downside protection in times of stock market volatility. However, assets like private real estate may complicate asset rebalancing schedules that rely on immediate liquidity.

If your investing strategy calls for disciplined adherence to strategic asset allocations, and a particular percentage held among asset classes over a long time horizon, then you may be best off with private real estate assets that offer regular cash flow, target a relatively short hold period, or both. Senior debt or preferred equity investments that offer a higher degree of investor protections and hold periods under two years may fit your portfolio best.

On the other hand, if you are further from retirement and have less rigidly-defined goals, your allocation strategy may have more room for longer-term, more opportunistic private real estate investments. If your investing goals are more loosely defined (e.g. “seek attractive risk-adjusted returns and compelling IRR”), frequent rebalancing is less critical, and a ground-up or value-add project that targets a longer hold with less timing certainty won’t pose a risk to your long-term investing strategy.

The Bottom Line

In our view, individual investors should pursue diversification across target hold periods and risk/return profiles and diversify into private-market alternates, much like institutional investors have for decades. This approach can capture upside potential while reducing liquidity risk. Strategic asset allocation is a useful concept but, like Modern Portfolio Theory, it is in need of some updating. Strict adherence to a frequent rebalancing schedule should not stand in the way of diversifying into less liquid assets that offer yield potential with low correlation to public markets.

Please note that while the EquityMultiple team is never short of opinions, we are not Financial Planners. For an in-depth discussion of these concepts in the context of your long-term goals, please consult a certified financial advisor.