Web-based research, planning, portfolio management and client reporting tool allows advisers to analyse a client’s attitude to risk and existing portfolios
Asset allocation is the foundation for building well-diversified portfolios. It offers a strategic approach to portfolio design by combining asset classes such as stocks, bonds and cash to meet an investor’s goals. For advisers – whether running your own asset allocation strategies or taking guidance from ready packaged asset models – it is of vital importance that the data powering your software solution is based on sound methodologies and a reliable set of expectations for returns, risk, and correlation.
Morningstar’s asset allocation tools draw heavily on the work of Ibbotson Associates, a unit of the Morningstar Investment Management division recognised worldwide for its academic research into asset allocation. Back in the early 1970s, in what would prove to be ground-breaking research, Ibbotson founder Roger G Ibbotson, along with Rex Sinquefield, researched and assembled the annual returns for several US asset classes dating back to 1926.
This seminal work allowed for the analysis of risk and return characteristics of different asset classes and today serves as a foundation for much of the modern asset allocation used in Morningstar’s software solutions for advisers.
Efficient frontier
Morningstar Adviser Workstation is a web-based research, planning, portfolio management and client-reporting platform. It provides access to Ibbotson asset allocation, capital market assumptions and asset models, and allows advisers to analyse a client’s attitude to risk and existing investment portfolios. The platform’s embedded risk-profiling and asset allocation tools are powered by models developed by Ibbotson Associates.
Inputs to asset allocation models typically include three types of assumptions about the behaviour of asset class returns: (1) the expected return of each asset class, (2) the volatility of the returns on each asset class, and (3) the correlation between the returns of each pair of asset classes. Diversification helps reduce portfolio risk; as the number of distinct asset classes in a portfolio increases, the total risk or volatility can be decreased up to a point without sacrificing expected return.
If risk cannot be further reduced without sacrificing expected return, the portfolio is said to be efficient. The set of all efficient portfolios is called the efficient frontier. In theory, investors should only choose among efficient frontiers.
The correlations among asset classes determine the degree to which risk can be reduced through diversification. The lower the correlations, the greater are the potential diversification benefits. Morningstar Adviser Workstation contains a tool known as a mean-variance optimiser that calculates the efficient frontier from the asset class assumptions. It can also impose various constraints on the portfolios selected, such as placing a maximum on equity exposure, to help ensure diversification or impose limits that the adviser and investor agree are needed.
Research has shown that expected return assumptions have great impact on the composition of efficient portfolios. Ibbotson Associates developed an approach to creating excepted return assumptions called the building-block approach. This combines current market data, such as bond yields, with historical performance relationships to build expected return assumptions that researchers at Ibbotson believe provide the best estimate of what market participants are expecting future long-term returns to be.
To assist your work in proposing the correct asset allocation mix based on your client’s risk profile, the Morningstar platform provides five strategic asset allocation guidance models that are aligned to the risk profiles generated by the embedded Morningstar risk tolerance questionnaire. Alternatively, the embedded methodology also allows advisers to create their own asset models based on Morningstar Investment Management’s capital market assumptions.
If choosing the latter, the asset allocation mix can be constructed through analysis of the various asset classes, their behaviours and how they blend.
The adviser is then able to match up investments to a proposed asset allocation to construct a portfolio. To build the portfolio will require the ability to understand the asset allocation breakdown of the investments being selected.
At Morningstar we insist on the collection of full holdings data from fund providers. Morningstar then classifies funds according to their asset breakdowns, enabling advisers to search for the funds that meet their needs with ease. This means that when you are looking at constructing a portfolio, you will do so based on comprehensive data that fits the asset models you are using.
All of the asset allocation tools described here are packaged into the investment advice process of Morningstar Adviser Workstation to enable advisers to run their clients through an investment process.
They can be combined with other research tools and data available through the platform, including Morningstar and OBSR’s forward-looking analyst ratings and research reports that provide in-depth analysis of approximately 700 funds available to investors in the UK.
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By Anastasia Georgiou and Paul Malone
Read more: http://www.investmentweek.co.uk/investment-week/feature/2124253/morningstar-workstation-aid-asset-allocation-decision/page/2#ixzz1eLW4qQrq