Asset Allocation – A Convenient Cop-Out for Pension Fund/Wealth Managers?
by Elliott R. Morss, Ph.D.
Introduction
The Asset Allocation Approach – we have all heard about how it is the most rational way to
invest. But is it? And why do investment managers like it so much? This article reviews the
arguments for the approach and why it is a favorite of wealth managers.
The Theory
Today’s dominant investment theory is derived from the writings of the mathematicians and
philosophers of the 16th Century1. Paul Samuelson2 is credited with developing the mathematical
theorem that “properly anticipated futures prices fluctuate randomly”. And Burton Malkiel has
presented all of this work in a book with direct application to personal investing.3
And what does it all mean for the investor? It means that the best assumption to start with is that
all available information on companies is reflected in their stock prices. Consequently, the price
of every stock is just as likely to go up or down. When you invest, you are making a random bet.
When new information comes out, prices will adjust immediately to reflect the implications of
this information.
This means the investor has 50-50 chance of picking which way a stock will move – not a good
bet because you don’t want a 50% chance that you will lose money on your investment. The
sensible conclusion: Don’t bet all your money on one horse: diversify; the more you diversify,
the more your chances of losing (or making) money on your investment will fall. And you can
diversify by purchasing more stocks, or a mutual fund or an ETF.
There is an important corollary to this: stock recommendations are close to worthless for the
retail investor: if new information is almost instantly reflected in stock prices, what makes you
think you are going to get that information in time to “cash in”? For more on what the retail
investor is up against, see my recent article.
The logic for using an asset allocation strategy is very powerful.
The Sector Scam
The people who want to charge you a fee to have them manage your money have taken the
meaning of diversification further. They have developed categories for stocks/bonds. They say
1
Andrew W. Lo and A. Craig MacKinlay, A Non-Random Walk Down Wall Street, (Princeton: Princeton
University Press, 2002).
2
Paul Samuelson, “Proof that Properly Discounted Present Values of Assets Vibrate Randomly”, Bell Journal of
Economics, 1973, 369-374.
3
Burton G. Malkiel, A Random Walk Down Wall Street: Including a Life-Cycle Guide to Personal Investing, (New
York: W.W. Norton 1973).
proper diversification requires that you have holdings in various sectors/categories. To give a
sense of how far the sector/category business has developed, the following are most of the
categories used by Morningstar to describe the approximately 25,000 mutual funds in their
database:
Bank Loan, Bear-Market, Conservative Allocation, Convertibles, Diversified Emerging Mkts, Diversified
Emerging Mkts, Diversified Pacific/Asia, Emerging Markets Bond, Europe Stock, Foreign Large Blend,
Foreign Large Growth, Foreign Large Value, Foreign Small/Mid Growth, Foreign Small/Mid Value, High
Yield Bond, High Yield Muni, Inflation-Protected Bond, Intermediate Government, Intermediate
Government, Intermediate-Term Bond, Japan Stock, Large Blend, Large Growth, Large Value, Latin
America Stock, Long Government, Long-Short, Long-Term Bond, Mid-Cap Blend, Mid-Cap Growth, MidCap Value, Moderate Allocation, Money Market – Muni, Money Market – Taxable, Multisector Bond,
Muni Single State Interm, Muni Single State Long, Muni Single State Short, Pacific/Asia ex-Japan Stk,
Short Government, Short-Term Bond, Small Blend, Small Growth, Small Growth, Small Value,
Communications, Financial, Health, Natural Resource, Precious Metals, Real Estate, Technology, Utilities,
Ultrashort Bond, World Allocation, World Bond, World Stock.
Indicies and ETFs have been developed for most of these.
Callan Associates, an institutional money consultant, has chosen 8 sector indices. To show how
these sectors have performed over the last 20 years, Callan has developed a chart with different
colors for different indices. A great marketing vehicle: different colors are at the top in different
years – the message – diversify – use our asset allocation method, and pay us for it!
Assessment
Boeckh just did a nice, representative piece on asset allocation. The article focused on
correlations between different sectors. Their message? Good asset allocation means holding
sectors that are not highly correlated with one another. No discussion of specific investment
vehicles.
Consider how convenient it is for investment advisors to focus on these sectors/categories. This
focus diverts the client’s attention from the important questions:
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How has the portfolio performed?
What stocks, funds, ETFs have actually been picked?
How have these picks performed relative to other possibilities in the same categories?
A Case In Point
I recently received “Investment Reviews” from a major bank where I am a trustee on a Trust.
The reviews were nicely presented in high-resolution color. The titles for the first four pages
were:
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p. 1 - “Strategic Asset Allocation Models”
p. 2 – “Hypothetical Model Portfolio Risk/Return”
p. 3 – “Strategic Asset Allocation Philosophy”
p. 4 – “Current Asset Allocation”.
There was nothing in these four pages on performance – nothing!
Only one page of these documents provided detail on performance, and that detail only broke
down performance into three categories: “Equity”, “Fixed Income”, and “Cash”. But nowhere in
the document was there any information on how each investment pick (stock or mutual fund) had
done! Why? Because the Trust manager did not want me to focus on actual investment picks and
how each pick actually performed.
The last few pages of “Investment Reviews” gave data on the individual investments, e.g.,
number of shares, market value, but without performance information on the individual
investment.
It turns out that a significant portion of the Trusts were invested in the Bank’s mutual funds. I
asked for and received performance data for these funds. I then compared their performance with
mutual funds that fall into the same Morningstar categories.
The essence of my review is contained in the following table. Each of the funds picked by the
bank fits nicely into Morningstar categories. Columns 2 provides the annualized 3-year return on
each fund. Column 3 provides the three year return ranking of each fund in the Morningstar
category. For example, in the Morningstar category of large cap growth, the Large Cap Growth
fund of the Bank ranked 500. This means there were 499 funds in the Morningstar category that
had better three-year performance than the Bank’s fund. Column 4 provides the best three year
return for a fund followed by Mornigstar in the category. For example, while the bank’s large
cap growth fund has an annualized three year return of 10.44%, the Morningstar fund with the
best return for that category was 24.59%. Column 5 provides the differential between the best
return and the return on the Bank’s fund.
(1)
(2)
(3)
(4)
(5)
3 Yr
3 Yr
Fund
3 Yr
Rank
Best
Differential
Tax Exempt
4.29
700
10.85
6.56
International Equity 21.72
116
32.26
10.54
Large Cap Growth
10.44
500
24.59
14.15
Large Cap Value
14.38
484
21.99
7.61
Mid Cap Growth
16.33
155
23.07
6.74
Mid Cap Value
17.79
60
26.18
8.39
Small Cap Growth
11.97
368
19.83
7.86
Small Cap Value
16.12
55
21.82
5.7
Core Bond
3.46
634
8.33
4.87
Source: Data provided by the bank and the Morningstar Principia data base.
This table demonstrates the sub-par performance of the Bank’s funds. The important message?
Specific investment choices matter! Remember that the people who invest your money want to
keep you as far away as they can from how your portfolio is performing. And most definitely,
they don’t want you to know how well each investment pick is doing relative to other possible
investment picks in the same category. Every wealth/pension manager has favorites in the
investment management industry s/he wants to give your money to. In the case of the bank
example above, the bank wanted to keep the money in-house by putting it in their crummy
mutual funds.
In these circumstances, what to do?
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Asset allocation logic is quite powerful.
Picking individual stocks should be viewed as gambling, a form of entertainment.
Find an investment advisor that has an audited 3-year performance record s/he is willing
to share with you (hard to find).
Once you have decided on an asset allocation strategy, make sure to pick relatively high
performing vehicles in each sector.