Approach creates a stronger link between asset allocation policy and the market environment

SEATTLE--(BUSINESS WIRE)-- Russell Investments’ latest research for institutional investors, entitled “Volatility-Responsive Asset Allocation,” explores the possibility of a dynamic asset allocation policy that varies as market volatility changes. The underlying principle of volatility-responsive asset allocation is to reduce exposure to risky assets when volatility is high, and to increase that exposure when volatility is low. According to the paper, a volatility-responsive asset allocation policy – which needs to be as systematic and disciplined as any other strategic policy – can lead to a more consistent outcome and a better trade-off between risk and return for institutional investors.

“Market volatility is itself volatile. Markets can be relatively stable at some points in time and explosively volatile at others,” said Michael Thomas, head of consulting and chief investment officer, Americas Institutional and one of the paper’s authors. “Given this fact, a strategic asset allocation policy is no longer necessarily a set of fixed weights that are held constant until the next review, because the associated risk can be highly variable over time. Rather, a strategic asset allocation policy can be designed to respond to changes in the investor’s experience or to changes in market valuations.”

According to the research authors (Thomas, Bob Collie, chief research strategist, and Mike Sylvanus, senior investment strategist), the foundation of a strategic asset allocation decision is a trade-off between risk and reward. Volatility is an appealing foundation for a dynamic strategy because, unlike the outlook for returns – which are notoriously difficult to forecast – investors can be relatively confident in their assessment of the volatility environment. One reason for this confidence is that changes in volatility are more persistent than changes in returns.

“The most impactful events in a portfolio occur at the extremes – 10 years of well-behaved markets can have less impact on the ultimate success or failure of a portfolio than a couple of outlier months of extreme returns. These extremes tend to be marked by high volatility, in which a 60/40 portfolio can easily behave like an 80/20 portfolio,” explained Thomas. “It isn’t reasonable to expect fiduciaries to stick with a policy portfolio when it starts behaving like a portfolio that they rejected in the strategic planning process. Historically, however, it has been difficult for investors to time these shifts such that they aren’t detrimental to performance.”

As part of the analysis, the authors looked at U.S. equity and U.S. fixed income, as represented by the Russell 3000® Index and the Barclays Capital U.S. Aggregate Bond Index. The simulation covered the period January 1979 – June 2011, the timeframe for which data on the Russell 3000 is available. (The strategy starts once 60 days’ return data is available from which to calculate trailing volatility.) The volatility-responsive strategy produced lower volatility than the fixed mix of 50 percent equity and 50 percent fixed income, and its volatility was more stable and predictable. There was also no return penalty over the period analyzed; the volatility-responsive strategy delivered an average 40 basis points higher return after accounting for trading costs.¹

“The idea of a dynamic adjustment to a strategic asset allocation is not new; there have always been some investors who vary their allocations because of changing return expectations. There’s also been a growing trend for pension plans to vary their allocations in line with funded status, an approach Russell first wrote about in April 2009 called “liability-responsive asset allocation,” said Collie. “These dynamic programs can easily integrate with one another. What’s new here is the idea of adding volatility to the list of factors driving the variation.”

About Russell Investments

Founded in 1936, Russell Investments is a global financial services firm that serves institutional investors, financial advisors and individuals in more than 40 countries.

Through a unique combination of interlinked businesses, Russell delivers financial products, services and advice. A pioneer, Russell began its strategic pension fund consulting business in 1969 and today is trusted by many well-known worldwide institutions for investment advice. Headquartered in Seattle, Washington, USA and with offices in major financial centers worldwide, Russell has $163 billion in assets under management (as of 6/30/2011) in its mutual funds, retirement products, and institutional funds, and is well recognized for its depth of research and quality of manager selection.

Russell offers a comprehensive range of implementation services that helps institutional clients maximize their assets. The Russell Indexes calculate over 50,000 benchmarks daily covering 65 countries and more than 10,000 securities.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Russell Investment Group, a Washington, USA corporation, operates through subsidiaries worldwide including Russell Investments. Russell Investment Group is a subsidiary of The Northwestern Mutual Life Insurance Company.

Russell Investments is the owner of the trademarks, service marks and copyrights related to its indexes.

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¹ Assumptions regarding trading costs were based on the average cost of trading and rolling futures contracts and had the effect of reducing the return for the volatility-responsive strategy by an additional 0.6 bps per year compared to the fixed-mix strategy (1.8 basis points versus 1.2 basis points)

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