“Don’t put all your eggs in one basket”
and quickly moves on to extolling the virtues of asset allocation. Much of this advice is centered around a widespread belief among brokers, financial advisors and clients that asset allocation is overwhelmingly the most important piece of the investment process. We agree that asset allocation is crucial in the development of an investment program and should be a prime focus of managers and fiduciaries. We take issue, however, with some of the conclusions that advisors and clients derive from the research that is heralded as “proving” the value of asset allocation.
One of the conclusions that many came to embrace as gospel is that the policy allocation is all that matters and that re-balancing portfolios is sacrosanct. Academic research conducted more than two decades ago found that asset allocation explains over 90% of the average fund’s return variance over time. This finding quickly became simplified to mean “Asset Allocation largely determines investment returns.” While the original study, produced by Brinson, Hood and Beebower in 1986, compared actual performance to weighted policy benchmarks to reach its conclusions, it did not separately account for the impact of market movements on portfolio returns. Later studies by Ibbotsen et al concluded that a combination of market movements and asset allocation explained the majority of return fluctuation.
The $64,000 question?
How much did market movements impact return fluctuations and how much did asset allocation impact them? Ibbotsen and others concluded that market movements account for most of the difference in returns, while long term strategic asset allocation accounted for a significantly smaller share.
This does not and should not diminish the importance of a well thought out and carefully developed strategic asset allocation. But it does suggest the need for an active approach in managing the investment process. Let’s take a look at a simplified 4 step process that Ibbotsen uses to explain his research. Begin by assuming you are in cash, then you go to an average asset mix (50% equity, 50% fixed income) and then you go to your specific asset allocation. Finally, you insert active management, which involves overweighting and underweighting certain asset classes, including cash. Ibbotsen found that going from cash to an average asset mix (the decision to get into the markets) accounts for approximately 70% of the return variation. The decision to use a specific asset allocation accounts for approximately 15% of the return variation, while the balance is due to active management, which is sometimes referred to as Tactical Asset Allocation. Tactical Asset Allocation represents tweaking the portfolio and should not be confused with market timing. While the research affirms the value of long term strategic asset allocation, it also credits tactical asset allocation as an important factor.
Tactical Asset Allocation provides the opportunity to better manage risk in a world that has become more risky. It would be nice and easy if we could simply come up with a long term allocation that made sense and was relevant to the organization’s mix of assets and liabilities and applied that allocation over time by routine re-balancing. Unfortunately, the “New Normal” environment we find ourselves in does not lend itself easily to the normal cycling of markets. The debt crisis, which started with mortgages and has moved on to sovereign debt, has been accurately described as being unprecedented (at least within memory of anyone alive). The ramifications are still playing out and you can reasonably expect results that are also unprecedented, or at least “not normal.” Shouldn’t your portfolio be managed with this in mind?
Another conclusion that the original study by Brinson et al spawned was that since asset allocation was all that mattered, indexed portfolios were superior due to lower costs and tracking error.