Approaches to building and measuring funds

The importance of asset allocation

Asset allocation is the process of adjusting the proportion of each asset class in an investment fund, in line with its investment goals. For example, if an asset manager anticipates that the stock market will perform well, it might adjust the asset allocation of the fund to favour equities.

As asset classes tend to generally move in the same direction – for example, bond markets tend to perform well when stock markets are struggling – asset allocation normally plays a significantly greater role in investment performance than the selection of individual investments.

Certain asset classes are considered generally riskier than others. For example, equities are considered a riskier investment than bonds as equity markets are normally more volatile than bond markets.

Blending asset classes

It’s possible to invest in multi-asset funds that contain various asset classes, such as stocks, bonds, cash and alternatives.

Multi-asset funds allow for a middle ground between a higher-risk stock-based approach and a lower-risk bond-based approach.

Having a larger ‘investible universe’ – meaning being able to invest in a wider range of assets – offers greater flexibility, allowing asset managers to better customise their funds to meet client goals.

Indices and benchmarks

Asset management firms compare their funds’ performance against benchmarks. A benchmark is usually a market index. Market indices provide a broad, representative portfolio of investment holdings, and are often used to represent the performance of different markets.

This comparison with benchmarks is useful because presenting a fund’s performance without context risks creating a misleading impression. For instance, if a fund made a return of 10% over the course of a year its performance is superficially positive. However, if the broader market returned 20% over the same period, it’s clear that the fund has underperformed in relative terms.

For example, the S&P 500 Index is a stock market index that lists the 500 largest US companies. This index is often used to represent the overall US stock market, which can make it a useful point of comparison. If a fund invests in US equities then the S&P 500 might serve as a benchmark, as it provides context on whether the fund is outperforming or underperforming relative to the broader market.

Many stock market indices exist, but there are also indices that track the performances of other markets, such as the bond and alternative markets.