Asset Allocation Still Drives Returns
Alternative Investments Play Important Role
|We agree with the conclusions of the Brinson, Hood, and Beebower research on asset allocation: more than 90% of the variation in portfolio returns can be explained by the asset allocation decision. Since asset allocation is the primary determinate of long-term returns, we focus our efforts on determining the most effective, or "optimal", asset allocation mix for our clients.|
|"Diversification overkill" describes the attempt by investors to incorporate an unwieldy number of asset classes in the portfolio construction process. To qualify for inclusion, asset classes must have a long and reliable stream of returns that appears to be quantifiably different enough to add diversification to a portfolio.|
|Our methodology identifies five unique asset classes within the universe of U.S. and foreign equity and fixed income securities. Additionally, we distinguish between large capitalization versus small capitalization and "value" versus "growth" in the equity classes.|
|Only those market sectors that exhibit sufficient pricing inefficiencies, such as small-cap stocks, should be captured through "active" management. Highly efficient market sectors should be indexed.|
|Due to their history of generating consistent performance that is not correlated with traditional asset classes, alternative strategies (i.e., hedge funds and managed futures) are an important component of a well-diversified portfolio.|
Modern Portfolio Theory (MPT): The Academic Foundation for Asset Allocation
Nearly forty years ago, Harry Markowitz revolutionized the investment management industry with his paper titled "Portfolio Selection" (Journal of Finance, March 1952). His work focused on the optimal selection of securities, based on a rational investor who sought to avoid any undo risk-taking.
Over the years, a number of the greatest minds in finance including Nobel prize winner William Sharpe and University of Chicago finance guru Eugene Fama built upon Markowitz’s ideas to develop the body of research referred to as "Modern Portfolio Theory." MPT introduced the notion that investing is a function of balancing risk and return. By combining asset classes or securities with differing return distributions and risk profiles, an optimal portfolio can be constructed that boasts better risk and return characteristics than any asset class or security considered exclusively.
Like many great ideas, MPT was initially shunned. Its unpopularity was partially pragmatic, as the computing time and muscle needed to balance a portfolio with only a few components was out of reach for all but the largest investors. But with the advent of faster, more powerful computers, sophisticated MPT analysis became possible to anyone with a personal computer and the appropriate software. In fact, MPT software is now relatively inexpensive and widely used for the benefit of large and small investors alike.
Another reason for the acceptance of MPT by the investment community was the passage of the Employee Retirement Income Security Act (ERISA) of 1974, which encouraged a more disciplined approach to asset management. ERISA’s core mandate was to prevent investment fiduciaries from establishing over-concentrated positions in a limited number of investments, which allowed for huge losses if things went awry. By spreading risk among a number of asset classes, the risk of loss is greatly diminished. Perhaps this explains the widespread use of the tools of MPT among the world’s largest and most sophisticated investors today.
The Application of MPT via Asset Allocation Works
But perhaps the most important reason for the nearly widespread use of MPT is that, quite simply, it works. Nothing brings the practicality of MPT better to light than the bear market of the early 1970s, a period where the most popular stocks (known at the time as the Nifty Fifty) lost 75 percent of their value while the rest of the market suffered far less. Investors with more broadly diversified investment mixes – including any combination of "value" stocks, foreign stocks, real estate securities, short-term fixed income, and managed futures within their traditional U.S. stock portfolio – better protected their wealth during this devastating market decline.
Similarly, diversified investors reduced the effect on their overall portfolio of the "Black Monday" U.S. stock market crash in October 1987. In the 1990’s, in spite of record-setting performance by U.S. growth stocks, investors muted stock market volatility and produced superior risk-adjusted returns through portfolio diversification. Today the U.S. stock market is experiencing unprecedented volatility as we conclude the first year of the new millennium. The technology-rich Nasdaq Composite Index nearly doubled in value in 1999 and created a new industry of "day trading" in the process. The glittery days of 1999 were revealed as fool’s gold in 2000 as the Nasdaq fell more than 60% from its intra-year high – approaching the sort of devastation recorded in the 1970’s Nifty Fifty debacle. While most stock prices tumbled in 2000, real estate securities, short-term fixed income, managed futures, and a variety of hedge fund strategies produced positive returns. In every decade since the 1970s diversified investors defended their wealth against the volatility and occasional savage losses associated with more concentrated portfolios.
The Risk of Non-Diversification
Perhaps the most powerful illustration of the power of diversification is to examine the returns of professional managers who shun the approach. Concentrated mutual funds – those that invest in a limited number of stocks with the greatest potential – commanded a majority of fund inflows in the last five years. These non-diversified funds are more risky than either the broad market indices or the average broadly diversified mutual fund. How did investors fare with these professionally managed vehicles? According to mutual fund ratings service Morningstar (www.morningstar.com), funds with fewer than thirty holdings either vastly outperform the market or lag it by a huge margin. For undiversified investors, there is little middle ground.
The bottom line: mutual fund managers who build non-diversified portfolios suffer the same experience as investors who concentrate their portfolios by asset class – the variation of returns is significant and the downside can be devastatingly bad. Also, recent research concludes that those managers that were skillful or lucky enough to beat the market in previous periods have no better odds of beating the market in the future than the random flip of a coin. If professional managers with large research budgets, access to company senior management, and other advantages of a professional perspective cannot produce superior returns with concentrated portfolios, what chance does an individual investor have?
One of the watershed events in the acceptance of asset allocation was the 1986 publication of a paper titled "Determinants of Portfolio Performance" in the Financial Analyst Journal. The article, and a 1991 follow up piece by the same authors (Brinson, Hood, and Beebower), proved to many the importance of the asset allocation process in explaining the returns from investing in paper assets. According to the Brinson study, more than 90 percent of the variation in portfolio returns can be explained by the asset allocation decision, while only 10 percent of the variation of returns can be explained by security selection and market timing efforts.
Although many investment professionals have misinterpreted the conclusions of this paper, a number of articles have confirmed the importance of the asset allocation process. A recent study by Ibbotson Associates, for example, showed that for long-term market participants who utilize indexed investments for a significant portion of their investment activity, the asset allocation decision indeed explains a majority of returns.
Many investment advisors have responded to this study by slicing the portfolio pie into myriad pieces with the virtuous intent of achieving optimal diversification. The U.S. equity market alone is now often split into as many as a dozen subcategories, and asset allocation software designed for planners routinely divvies the investment world into more than fifty different groups. One program reportedly designates 1,000 asset classes, including Turkish utilities and lard futures.
This is clearly extreme. As the number of asset classes included in the portfolio increase, the costs incurred by clients tend to rise, as does the time required to follow a larger number of market indices. Thus, investment advisors often walk a fine line between diversifying portfolios either too much or not enough. In brief, we look for asset classes with a long and verifiable stream of returns that appear quantifiably different enough to add meaningful diversification to a portfolio.
Our research has led us to recommend the inclusion of five distinct traditional asset classes in Sovereign Wealth Management portfolios. These five classes include domestic and foreign equity and fixed income securities and alternative investments. Within the equity asset classes we make distinctions between small versus large capitalization and "value" versus "growth" securities. Long-term market returns document an additional return associated with small company stocks (versus large company stocks) and value stocks (versus growth stocks).Passive versus Active Management
The debate over market efficiency rages on. Academics and distributors of passive mutual fund investments, armed with evidence of manager futility in outperforming market indices, effectively argue the benefits of index fund investing. Contrary opinions are supported by specific evidence of market inefficiencies and superior long-term performance for individual managers. We believe that successful investing results from a combination of passive and active management. Specifically, those market sectors that exhibit sufficient pricing inefficiencies should be captured by allocations to managers that attempt to add value over the implicit return of the sector through active security selection. Market sectors that do not demonstrate such inefficiencies should be pursued through a low-cost index-style investment strategy.
Small cap stocks certainly fit into this former category. In stark contrast to the dismal performance of active large cap managers, a majority of active small cap managers exceeded the return of their benchmark (i.e., the Russell 2000 index) during most of the 1990s. This difference in performance is likely due to difficulty in obtaining information about small cap stocks. Whereas stocks in the S&P 500 index are followed by an average of 16 analysts, an average of only four analysts track stocks in the Russell 2000 index. Ultimately, good managers should distinguish themselves by identifying and exploiting pricing inefficiencies to produce superior risk-adjusted returns. In addition to small capitalization U.S. stocks, exploitable inefficiencies appear to exist in foreign stocks and high yield corporate bonds.Alternative Investments: Powerful Diversification Tools
In the last two decades of the 20th century new forms of investment emerged that are referred to as "alternative" investments. These non-traditional investment strategies are further classified as either "hedge funds" or "managed futures". Such investments have produced returns that are very different from the returns of the more traditional stock and bond markets. When two investments behave differently over common time periods they are considered non-correlated. Non-correlated investments produce significant diversification benefits when combined in a portfolio.
For the past decade the risk-adjusted returns for many hedge fund strategies has exceeded the risk-adjusted returns of U.S. stock market investments. The combination of attractive absolute returns and non-correlation to traditional asset classes provides a compelling incentive for including alternative investments in a well-diversified investment portfolio.
The mission at Sovereign Wealth Management is to provide our clients with wealth management services that result in performance exceeding their investment goals and objectives. Exposing our clients to undo risk is contrary to this mission. We believe that the tools of Modern Portfolio Theory empower us with a methodology for building superior investment portfolios. This methodology has been tested in all types of market conditions for several decades and has consistently protected investor wealth from the perils of non-diversification.
Recent academic research suggests that 90% of the variation of portfolio returns are determined by the asset allocation decision. Less than 10% of the variation is attributable to security selection and market timing efforts. An outgrowth of this groundbreaking research is what we call "diversification overkill". This refers to the tendency of well-intended financial advisors and investors to divide investment capital among an excessive number of asset classes.
At Sovereign Wealth Management we require a long and verifiable stream of returns different enough to add meaningful diversification to a portfolio. When we apply these criteria to our process the result is an allocation to four traditional asset classes (in addition to the allocation to alternative investments). These asset classes include domestic and foreign stocks and bonds. Additionally, size (large versus small) and "valueness" (value versus growth) further classify equity asset classes. Finally, certain asset class returns – those that exhibit significant pricing inefficiencies – are captured through an active management style, while others are accessed through a low cost, passive index-style approach.
Alternative investment strategies offer tremendous diversification benefits for traditional portfolios. Historical returns for managed futures and hedge fund investments have been attractive as well as non-correlated to stock and bond benchmarks. We believe that certain alternative investment strategies include a systemic return independent of manager skill. An intelligent allocation to non-traditional investment strategies is an important part of a well-diversified portfolio.