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ASSET ALLOCATION |USING STOCKS AND BOND FUTURES- AN EFFICIENT INVESTMENT STRATEGY

Updated on July 29, 2015

Assets allocation is an attempt made by investment managers / portfolio managers to attach weighs to the performance of individual assets in a portfolio- how an investment portfolio is allocated across assets classes.

WHAT ARE CONTAINED IN AN INVESTMENT PORTFOLIO?

 

A typical investment portfolio often consists of money allocated to classes of assets according to the perceived importance- in terms of returns and other investment performance measurement variables.

Assets can be classed as general stock, general bonds, general real estate, venture capital, or commodities. These classes of assets can be subdivided into specific classes of assets to reflect the assets allocation strategy of the assets portfolio manager.

Portfolio managers attempt to adjust the allocation of available funds amongst assets classes in such a way that the class of assets with the highest weight will get the highest assets allocated to it. This is a portfolio management theory called asset allocation.

Strategic asset allocation is an allocation / distribution of funds formula designed by fund managers to reflect their long run experience/desire of portfolio management. Portfolio managers can however deviate from the strategic asset allocation formula/ weights to use a short term allocation weights- this short term deviation is called a tactical asset allocation. Note that both strategic asset allocation and tactical asset allocation are investment management styles.

Portfolio managers use tactical asset allocation strategies within the various classes asset. These are done when futures are available on underlying (i.e. assets which derivatives are based) that are sufficiently similar to the asset classes. These are often used to execute strategies in a more efficient, less costly manner.

The question at this point is; how is this asset allocation done?

Stock index and bond futures can be used to efficiently execute asset allocation strategies involving stock and bond asset classes. A simple example will be used to demonstrate this. Let us look at a manager with portfolio that contains just two assets classes; stock and bonds. If the manager wants to reduce the allocation to stock and increase the allocation to bonds, he or she can do so by selling shares and buying bonds.

The portfolio manager can however chose to sell shares futures and buy bond futures to achieve the same desired result. Suitability of the use of derivatives depends on the similarity that exist between the underlying derivatives (stock index futures and bond futures.) assuming that both assets are similar so that we can use shares and bonds futures to achieve tactical asset allocation.

Suppose the portfolio manager decides to a sell a portion of the stock and buy same proportion of bonds. Stock market timing formula for futures can be used to determine the number of futures contracts to at the same time adjust the beta on that given amount of shares from its current level to zero. This will ensure that stocks are sold and converted to cash. Note that the cash we are talking about here are synthetically generated and needs to be converted to bond. To do this, the fund manager will buy bond futures to adjust the duration on this synthetic cash from zero to its desired level, which is the duration of the existing bond portion of the portfolio.

Notice that the shares and bond mix in the portfolio did not change, what only happened was that the allocation changed by the introduction of synthetically generated stock index futures and bond futures.

Now, if the asset manager wishes to change the risk characteristics of the already existing shares and bond asset classes, we can then adjust the beta on the stock by purchasing or selling more stock index futures contracts, also adjust the duration on bonds by buying or selling more bond futures contracts.

ASSETS ALLOCATION TERMS THAT YOU MUST BE FAMILIAR WITH

BETA: beta is a measure of the responsiveness of a security or portfolio to the market as a whole.

DURATION: duration is a measure of the size and timing of a bond’s cash flows. It also reflects the weighted average maturity of the bond and indicates the sensitivity of the bond’s price to a change in its yield.

STOCK INDEX: stock index is a combination of shares prices that is designed to serve as a measurement criteria to the shares as a whole.

FUTURE contract: a futures contract is a legal agreement between two parties (individuals or corporate bodies)- buyer and seller- to buy an asset or currency at a future date at a fixed price and that trades on a futures exchange and is subject to a daily settlement procedures in order to guarantee promptness of claim settlements.

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