Portfolio Performance and Strategic Asset Allocation Across Different Economic Conditions

Abstract

Motivated by the theoretical results on strategic asset allocation, we examine the gains in portfolio performance when investors diversify into different asset classes, with particular focus on the timeliness of such gains. Although the various asset classes we analyze yield significant gains in portfolio performance, even in the presence of short sales constraints, the timeliness of the gains differs considerably across the asset classes. Our key result is that commodities and precious metals, and equity REITs are the two asset classes that deliver portfolio gains when consumption growth is low and/or volatile, i.e., when investors really care for such benefits. Consistent with these results, our examination of investor portfolio allocations using a regime switching framework reveals that during the 'bad' economic state, the mean-variance optimal risky portfolio is tilted towards equity REITs, precious metals, and Treasury bonds. Our analysis highlights an important metric by which to judge the attractiveness of an asset class in a portfolio context, namely the timeliness of the gains in portfolio performance.