Issues in Asset Allocation

19.2 Issues in Asset Allocation

Introduction

Asset allocation is often cited as the single most important decision in the investment process. While deciding how to distribute capital among equities, fixed income, cash, and alternative investments might seem straightforward, multiple issues can complicate this process. In the Canadian context, these complications are magnified by tax considerations, currency risks, and evolving regulations coordinated by the Canadian Investment Regulatory Organization (CIRO). This section examines the most common challenges faced by Canadian investors and wealth advisors when formulating and implementing an asset allocation strategy.

Market Volatility

Market volatility, defined as rapid and significant price fluctuations in the securities markets, can lead to sudden gains or losses, causing investors to reconsider their long-term strategies. In volatile times, emotional responses—such as panic selling or unplanned shifts toward cash—can undermine strategic allocation.

• Volatility spikes often correlate with global or local geopolitical events, such as trade disputes or changes in monetary policy by the Bank of Canada.
• Large institutional players like the Canada Pension Plan Investment Board (CPPIB) often plan for market swings by diversifying across regions and asset classes—aiming to smooth out overall returns despite short-term fluctuations.

Transaction Costs

Implementing an asset allocation strategy naturally involves transaction costs such as brokerage fees, commissions, and spreads:

• Frequent rebalancing can amplify these costs, particularly if you employ tactical allocations (e.g., short-term adjustments to capture perceived opportunities).
• Canadian investors may incur additional fees if they invest in foreign securities (e.g., foreign exchange fees).
• Major Canadian banks (e.g., RBC, TD, BMO) often provide special fee structures or commission schedules for wealth management clients. However, frequent trading can still erode returns if not carefully managed.

Tip:
Evaluating trading frequency versus expected benefit from tactical shifts is crucial. Consider whether the incremental gain justifies the associated transaction costs.

Tax Considerations in Canada

Tax treatment in Canada varies significantly among investment vehicles, prompting advisors to carefully position assets for optimal after-tax returns:

• Registered Retirement Savings Plans (RRSPs) offer tax-deferred growth, so allocations with high growth potential (e.g., equities) can be well-suited within RRSPs.
• Tax-Free Savings Accounts (TFSAs) allow tax-free growth, making them ideal for highly-appreciating assets and for individuals who expect a higher tax bracket in retirement.
• Non-registered accounts are subject to annual taxation on dividends, interest, and capital gains, but the tax rates differ:
  • Dividends from Canadian corporations may qualify for the dividend tax credit.
  • Capital gains are effectively taxed at 50% of your marginal rate.

Pitfall:
Ignoring the interplay of asset location and taxes can substantially reduce net returns. Review CRA (Canada Revenue Agency) guidelines for updated tax rates, deduction limits, and reporting rules: https://www.canada.ca/en/revenue-agency

Correlation Shifts

Correlation—how two securities or asset classes move relative to each other—can change over time, especially during market stress:

• In normal markets, asset classes may appear uncorrelated (or negatively correlated), providing a diversification benefit.
• In a crisis, correlations often converge (i.e., almost all asset prices fall simultaneously), reducing diversification advantages.
• Understanding correlation dynamics is essential for optimizing portfolio risk, especially when shifting allocations in response to market signals.

    flowchart LR
	    A[Investor] --> B[Allocate to Equities]
	    A --> C[Allocate to Bonds]
	    A --> D[Allocate to Alternatives]
	    B --> E[Capital Gains / Dividends]
	    C --> F[Interest Income]
	    D --> G[Hedge or Diversification Benefits]

In the above diagram, you can see how an investor’s capital flows into various asset choices. During times of stress, the correlation between Equities (B) and Alternatives (D) may increase, reducing diversification benefits.

Formula Spotlight: Correlation & Portfolio Variance
When combining two assets, the portfolio variance ($\sigma_p^2$) is:

$$ \sigma_p^2 = w_1^2 \sigma_1^2 + w_2^2 \sigma_2^2 + 2, w_1 w_2 ,\rho_{1,2},\sigma_1,\sigma_2 $$

Where:

• \( w_i \) = weight of each asset in the portfolio
• \( \sigma_i \) = standard deviation of each asset
• \( \rho_{1,2} \) = correlation between the two assets

Note how a change in correlation (\(\rho_{1,2}\)) significantly impacts overall portfolio volatility.

Behavioral Biases

Human psychology can cause suboptimal investment decisions, especially during market turbulence. Two notable biases are:

1. Loss Aversion: The tendency to feel the pain of losses more acutely than the pleasure of gains, often leading to premature selling when prices dip.
2. Recency Bias: Placing excessive weight on recent performance rather than long-term trends, which can lead to chasing hot sectors or abandoning fundamentally solid positions.

Tip:
Advisors can mitigate these biases by:

• Establishing clear, rules-based asset allocation processes.
• Educating clients on the importance of staying committed to longer-term strategies.
• Offering scenario analyses to illustrate potential outcomes of emotional vs. disciplined decisions.

Online courses on behavioral finance (e.g., offered through Coursera or edX) can deepen understanding of these biases and their impact on asset allocation.

Local and Global Geopolitical Risks

Sudden geopolitical shifts—such as changes in trade policies, political turmoil, or global health crises—can rapidly alter market sentiment and risk profiles:

• Canadian commodity-driven sectors (e.g., energy, metals) may be particularly sensitive to global events.
• Domestic political developments, such as changes in corporate taxation or environmental policies, affect certain industries more than others.
• Diversifying across multiple geographic regions can mitigate concentration risk from localized events, but it also introduces currency risk for Canadian dollar (CAD) holders.

Currency Exchange Risks

Holding foreign equities and bonds can enhance diversification and return potential, but it exposes investors to currency fluctuations:

• When the Canadian dollar weakens, CAD-converted returns from foreign assets may improve, and vice versa.
• Hedged and unhedged products are available to manage currency exposure. For instance, many Canadian ETFs offer CAD-hedged versions of popular international benchmarks.
• Large Canadian banks (like RBC) provide hedging instruments that can limit currency risk, though these carry fees and may forego some upside.

Practical Asset Allocation Approaches

Investors can consider different approaches to navigate the issues above:

1. Strategic Asset Allocation (SAA)

   • Focus on a long-term, target blend of assets.
   • Rebalance periodically (e.g., annually or semi-annually) to maintain target weights.
   • Minimizes transaction costs by limiting frequent trades.

2. Tactical Asset Allocation (TAA)

   • Seeks to outperform a strategic mix by exploiting short-term market opportunities.
   • Higher transaction costs and volatility in allocation percentages.
   • May be beneficial if you have strong views on, or proprietary research into, market movements.

3. Core-Satellite Strategy

   • Maintain a “core” portfolio (often ETFs or mutual funds tracking broad indices) to capture market returns.
   • Add “satellites," which can be specific sectors or styles (e.g., technology, dividend-growers, emerging markets) to boost alpha or hedge risk.

Additional Resources

• CIRO: See CIRO’s website for guidelines on regulatory compliance, best practices, and investor protection information.
• CRA: Visit CRA’s official site for details on RRSP and TFSA contribution limits, capital gains taxation, and investor tax credits.
• “Asset Allocation: Balancing Financial Risk” by Roger C. Gibson: Offers deeper insights into handling common and specialized issues in asset allocation.
• Behavioural Finance Courses on edX or Coursera: Enhance your understanding of how biases can distort investment decisions.

Key Takeaways

1. Plan for Volatility: Anticipate market swings through consistent, rules-based rebalancing to avoid emotional decision-making.
2. Mind Costs and Taxes: Transaction costs and tax treatment can substantially alter real returns; optimize asset location across RRSPs, TFSAs, and non-registered accounts.
3. Watch Correlation: The diversification benefits of allocation can diminish during market stress if correlations rise.
4. Manage Behavior: Awareness of loss aversion and recency bias is critical. Structured processes and clear guidelines help maintain discipline.
5. Stay Informed: Keep track of Canadian regulatory changes, global events, and currency movements that can affect portfolio performance.

Advanced Asset Allocation Strategies in Canada: Test Your Knowledge