The ABC’s of Asset Allocation
“Choosing an asset allocation is one of the most important decisions that investors make.” – Rodgers & Associates, 2016
“In a landmark paper published in 1986, “Determinants of Portfolio Performance,” Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower concluded that asset allocation is the primary determinant of a portfolio’s return variability, with security selection and market-timing playing minor roles.” – Vanguard, 2006
“In summary, our analysis shows that asset allocation explains about 90 percent of the variability of a fund’s returns over time” – Roger G. Ibbotson and Paul D. Kaplan, 2001
The above quotes are just a sample; investors across the markets are clear on the importance of asset allocation. Equitas shares this view. Asset allocation is so important that we often place it in the front of investment policy statements, and we recommend for institutions to review their asset allocations annually. As important as this topic is, we still see plenty of questions and misunderstandings. These questions are understandable, particularly since a very large asset gatherer has their own particular view on the topic. We will address that later, but for now, let’s get some disclaimers out of the way so that we can cover the basics:
It is important to keep in mind that asset allocation studies are not intended as a tool to time the market. Rather, the studies are intended as a long-term planning tool, and only indicate how different asset classes are expected to perform over long periods of time (more than 5 years). Given a long-term time horizon, you can take reasonable investment risks with the expectation that this may yield you higher returns. Time does have a moderating effect on risk (standard deviation), and with a longer time horizon, you can increase your chances of a positive rate of return on your investments. Investments inherently involve risk, including the risk of loss of capital invested. Past performance is not a guarantee of future results.
ABC’s of Asset Allocation
Asset Allocation is simply the name that we give to the mix of investments that make up a given portfolio. Beyond just Apple vs Microsoft stock, Asset Allocation typically refers to broader asset classes like United States Equity, Foreign Equity, United States Bonds, Foreign Bonds, Real Estate, Commodities, Private Equity, and Hedge Funds. Many firms break out large cap stocks and small cap stocks into different asset classes. Some break them out further by Value vs Growth style. The question of “Which asset classes should I use?” is answered in many ways, but generally includes between 5 and 10 separate asset classes or sources of market beta.
Separate sources of beta are generally used in order to diversify portfolios to reduce the level of systemic risk within a portfolio. For example, a portfolio consisting of all large-cap US stock did very well in 2017 when the S&P 500 earned 22%, but did very poorly in 2008 when it lost 37%. The chart on the next page displays the returns of several asset classes, along with a diversified portfolio labeled “AA.”
For many investors, the variance in returns of a single asset class causes material discomfort. Furthermore, diversification and rebalancing are beneficial to portfolios over time. Thus, many modern portfolios include several asset classes and are rebalanced regularly. One very common pitfall is for a portfolio to be “diversified” among US stocks and bonds, without including international or alternative assets. These asset classes can be considered portfolio “ingredients.” However, you need more than just ingredients to bake a cake; you also need a recipe that tells you how much of each ingredient.
Which recipe to use?
To find this recipe, many professionals use asset allocation studies, which are a blending exercise to find the most efficient mix of asset classes per unit of risk taken. These studies use mathematical properties (Capital Market Assumptions) about the different asset classes as inputs to output a series of efficient portfolios. The absolute numbers are not as important as the relative values between each asset. The Capital Market Assumptions are paramount for an asset allocation study, and often change from year to year.
The first appearance of asset allocation in literature appears to be from the year 500 A.D. The Babylonian text reads “One should always divide his wealth into three parts: a third in land, a third in merchandise, and a third ready to hand.” While it is possible that this was good advice for the time, Equitas prefers the objective, time-tested building blocks of Markowitz and the Capital Asset Pricing Model (CAPM).
Modern Portfolio Theory
In 1952, Economist Harry Markowitz introduced Modern Portfolio Theory with his essay titled “Portfolio Selection.” In 1990, the Royal Swedish Academy of Sciences awarded the Nobel Memorial Prize in Economics to Markowitz for this theory of portfolio choice. In his essay, Markowitz uses assumptions about rational investors and markets to find an “efficient frontier” of portfolios that maximize return for any given level of risk. While this work remains extremely important, a flaw remained in that future returns do not always equal historical returns. Decades after the original publication of “Portfolio Selection,” Fischer Black and Robert Litterman published a solution to this problem in 1992. This model starts with the assumption that an investor can approximate the “market allocation” by using the market cap of various asset classes. They then use that assumption to work backwards to “discover” the implied future returns created by this market allocation. This model also allows an individual investor to apply his or her own view. Equitas Capital Advisors uses this method every year to calculate the Capital Asset Market Assumptions we use for our clients.
From time to time, our on-going research reveals other investment managers who decide to use another process. For example, JP Morgan formulates their Capital Asset Market Assumptions as part of a proprietary process where they look beyond the numbers, including assumptions from their staff. In the 2018 edition of their assumptions, they considered the effects of secular themes, including global aging and technological innovation, and cyclical factors—notably the slow path of policy normalization and elevated equity valuations—that they believe will influence asset returns over our 10- to 15-year investment horizon. During this period, they expect more modest returns in many asset markets, and subjectively lowered their assumptions accordingly. More specifically, their qualitative methodology starts with a model that was originally developed for firm specific projections. Then, they modify that methodology in attempt to apply it to the entire economy as a whole. This model involves more assumptions (uncertainty) about the US economy, and further requires that these assumptions remain constant in the projection rather than the variable nature they have expressed historically. We tend to default to the Nobel awarded Markowitz/Black-Litterman methodology which was designed specifically for this purpose, and has served us well over our tenure.
Many smart investors try to predict, and time the markets using what they imagine to be an informational advantage, or what is commonly called guessing. In 2014, CXO Advisory Group set out to perform a study of whether industry experts were able to accurately time the markets. They scoured the web for predictions, and found 28 “gurus” who had more than 100 predictions during the period 2000 to 2012. As a background, previously Will Sharpe published a study on market timing that suggests that a market timer would have to be right and average of 74% of the time in order to beat a simple buy and hold strategy. The results, which we believe speak for themselves, are shown in the below table.
Is your Asset Allocation on the Black-Litterman Efficient Frontier? Contact our offices at 504-569-9600 to find out.
Equitas Capital Advisors, LLC was established in 2002 as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.
Disclosures and Disclaimers:
Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.
Equitas Capital Advisors, LLC is registered as an investment advisor with the U.S. Securities and Exchange Commission (“SEC”) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.
Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.
Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
All investment strategies have the potential for profit or loss. There can be no assurances that an investor’s portfolio will match or outperform any particular benchmark. Past performance does not guarantee future investment