It was twenty years ago when "Determinants of Fund Performance" by Gary Brinson, Randolph Hood, and Gil Beebower put asset allocation on the map by finding that how assets were allocated accounted for 93.6 percent of portfolio performance. (see Fund Q & A, March, p.66) Asset allocation models quickly became the rock upon which advisors built their practice and traditionally have implied a one-time decision on the ideal division between equities and bonds, a commitment to a buy-and-hold strategy, and an annual review to re-balance the portfolio if percentages strayed significantly from the original targets.
Today, just how much asset allocation accounts for portfolio returns and whether it was return or portfolio variance that the groundbreaking Brinson study measured is a matter of debate--a pointless exercise in the opinion of Harold Evensky, CFP, of Evensky & Katz in Coral Gables, Fla. "It doesn't matter whether asset allocation accounts for 93.6 percent or 75 percent, or less than that," he says. "The point is that the diversification that occurs with broad asset allocation is overwhelmingly important to portfolio returns, especially if you don't believe you can market time."
In fact, asset allocation is so important to returns that in today's increasingly competitive and meandering market, advisors are making some changes to the classic asset allocation model and adopting what Kathleen Day, CFP, CFA, of The Enrichment Group, Miami, Fla., calls a "more forward-looking approach" for portfolio design. "Traditional asset allocation was highly dependent on historical data and we feel there has to be some forward-looking asset allocation based on what we anticipate the market is going to do," Day explains.
Enter core and satellite
Because Evensky anticipates modest equity returns for a prolonged period, his current focus is not on picking top-performing managers, but on controlling the impact of taxes and fund expenses on portfolio returns. Moving his firm from the "traditional two-dimensional institutional environment that distributes assets according to risk and return to the three-dimensional real world where returns are impacted by expenses and taxes" has resulted in a transition from multi-asset class, multi-style portfolios with numerous managers to a middle-ground of index funds, TIPs and ETFs to its current focus on a core and satellite structure.
Evensky's core is designed to capture the return of the broad U.S. stock market in the most cost-effective, tax-efficient manner while the opportunistic satellites are expected to perform 2 percent better than the core.
"The core represents about 80 percent of the equity allocation for most clients and has a tilt toward value and small-cap stocks because historically they have delivered greater returns," Evensky explains. "Although it could just as well be the S&P 500 Index, our domestic core is comprised of the Russell 3000, S&P 400, and DFA's small-cap value fund. For international exposure, we use the Julius Baer International Equity fund, the only actively managed fund in our core."
Satellites account for 20 percent of Evensky's equity allocation, and here anything goes. "The manager doesn't have to be style consistent. It can be a sector fund or an industry fund. The investment can be expensive or tax inefficient," he explains. "Our only criteria are we think it is a fundamentally sound investment strategy, not a gimmick, and we expect it to generate 2 percent more than our core."
As a general rule, Evensky divides the satellite into four or five pieces. "We don't want to make a big bet on any one area," he explains "We're currently invested in an investment that is shorting 30-year Treasuries, an iShare for the Russell 1000, the Mathews Asia Pacific fund for its exposures to the emerging markets of Japan and Korea, and the PIMCO Developed Local Currency fund, a play on emerging markets' money markets."
Evensky allows that making "tactical bets in portfolio design" has brought a new decision making process to the firm. He explains, "In the past when we invested in emerging markets and commodities in our satellites, we've had to ask ourselves: 'Why are we staying in? Are we being greedy?' Of course, we've developed criteria for when to invest and when to get out, but admittedly, it is more of an art than a science."
From pie chart to bull's-eye
At The Enrichment Group, Day's core and satellite portfolio structure is composed of three parts: a tax-efficient, low-cost stable core; slightly more expensive buy-and-hold investments where active management strives to generate alpha; and a tactical layer made up of non-correlated asset classes such as REITS, commodities, and high yield bonds. "For the most part the outer layer is comprised of very actively managed strategies such as long-short, merger arbitrage and convertible arbitrage that historically have been available only in hedge funds, but now are available in mutual funds," explains Day's Enrichment Group colleague, Mitchell Marenus, CFP, CFA.
While the firm looks for opportunity in the outer band and has the ability to move in and out quickly, Day stresses to clients that this is not market timing. "We're not making all or nothing moves in and out of major asset classes," she says. "Rather, we're looking at the sector level. If we don't want to own a particular sector that is overpriced right now, we look for something that's under priced that we could own instead. For example, we held REITS for three years or so, but a year or so ago they began to look very high-priced, so we sold half of our position and the other half eight months later."
Day stresses the firm doesn't make these tactical decisions in a vacuum. In fact, in addition to the seven planners who make up her firm's investment committee, she also invites planners from other firms to sit in on The Enrichment Group's investment meetings. "These advisors have different viewpoints, and we want to hear them," she says.
While percentages vary according to the risk tolerance of the clients, there are elements of all three components in every portfolio, a division the firm represents not with the traditional pie chart, but with a bull's-eye.
Marenus says the bull's-eye also helps illustrate the notion that you get what you pay for. "Looking at the allocation as a bull's-eye target rather than a pie chart helps to explain the goal of adding alpha. The further away from the center you are, the more important active management is and the more skill the manager has to have-- and investors pay for that."
This is not to say, however, that costs don't matter in Day's outer ring. Although she has considered funds of funds for their diversification benefit, she found the two layers of fund management fees made the costs too high. In an additional move toward cost control, Day has several options in each category to allow for more tax-efficient choices in taxable accounts.
Adds Marenus, "Generally, the core works okay in taxable accounts, but in the outer ring there may be more activity, more turnover, and therefore we may want to keep those funds in vehicles like IRAs."
Core with global reach
In another twist on the core and satellite, Richard Moran, CFP, at Moran, Kimura & Heising, LLC, in Torrance, Calif., employs his trademark global reach. "Today's typical client has 50 percent invested internationally, up from the 30 percent range for the last two decades because the argument for international diversification has grown stronger," Moran explains. "We've seen a complete reversal of worldwide gross domestic product (GDP). Thirty years ago, 70 percent of GDP was generated by U.S. companies. Now it's 50/50. My bet is that 20 years from now the GDP split could be 30 percent U.S. companies and 70 percent foreign."
Moran pitches his equity core with a 50/50 domestic/foreign split as a market neutral approach. "If we invest any other way than 50/50, we'd be biased," he says. "It's ideal to weight portfolios in line with world market capitalization."
Typically, both Moran's domestic and international core allocations are made up of three funds: a large cap growth fund, large-cap value fund, and a small-cap fund that is typically a blend fund. On the international side, he is careful to evaluate where the fund invests, and that accounts for somewhat more active management than he uses on the domestic side. "We currently have one international large-cap value fund that has been under-performing and, although we normally would sell it, it's invested 24 percent in Japan, an area we think is going to do well, so we'll continue to hold the fund," he notes.
While Moran's satellites are tactical allocations, he's willing to be patient for the boost to returns. In the recent past, he's used REITS, emerging markets, junk bonds, technology funds and a deep value fund. Currently he's using TIPs, commodity funds, and an Asia Pacific fund.
"We prefer our satellite investments to be so deeply undervalued that they are a screaming bargain," he says. "REITs were like that a few years ago; so were junk bonds. Generally, we are prepared to wait two to three years for our satellite investments to boost returns. We'll also consider an asset class that has current momentum that for some reason we believe will last for a while."
Either way, satellites never account for more than 30 percent of a portfolio, and much more often are in the 10 percent to 20 percent range. "At that level, we can make a difference if we are right, but not hurt clients too much if we are wrong," says Moran.
The more things change...
The tactical quest to additional return doesn't sit well with Roger Gibson, CFP, CFA, of Gibson Capital Management in Pittsburgh, and author of the classic text Asset Allocation: Balancing Financial Risk. For two decades, Gibson has added value by diversifying the equity portion of his client portfolios among four non-correlating asset classes: U.S. stocks, non-U.S. stocks, real estate, and commodities-- and he's not about to change and make decisions whether to be active or passive asset class by asset class.
"Not only doesn't over-weighting and under-weighting asset classes work, it introduces a counter-productive decision-making headset," he says. "For a planner to underweight a particular equity asset class and overweight another one says, 'I have an informed judgment about the relative value of all of the asset classes, and I see something that the rest of the market is missing.' That's a bold assertion. I just don't believe people can do that. On average and over time, clients are going to get hurt with this approach--and so advisors are going to get hurt."
Gibson cautions advisors to consider how they will respond when an asset class they expect will outperform doesn't. "Advisors need to be careful how they try and distinguish themselves. We are accountable to our worldview. And my worldview is I don't know how to overweight and underweight asset classes in the short-run because I don't know what is going to happen in the future," he says.
How does Gibson pursue better returns? "Broader diversification than what the client presently has will accomplish both of those things, and the good news is it's not skill dependent. We don't believe it is possible to pick the market's turning points. Rather, we rely on the risk reduction and volatility reduction that accompanies broader diversification," he explains. "Asset classes beyond U.S. and non-U.S. stocks and bond market did extraordinarily well in the bear market. For instance, the cumulative performance from March 31 of 2000 through end of 2005, just shy 6 years, REITs were 195.4 percent, just shy of cumulatively tripling, and commodities were up 112%, more than doubling," he notes.
Continues Gibson, "We tell clients each asset class is capable of producing stunning single period losses as well as multiple year periods with below average returns. The good news is they don't tend to do it together in lock-step and that has a wonderful effect with risk and volatility reduction. It's like different cylinders in a car. You don't want them to fire at the same time, the engine will blow up and you won't be going anywhere. If the cylinders take turns firing, that keeps the automobile moving forward. Similarly, diversification keeps the portfolio moving at a reasonable pace."
The alternative arena
Of course, a reasonable rate of return is relative, and many advisors are casting a broader net to keep portfolios moving in a positive direction. Diane Pearson, CFP, is director of financial planning at the Pittsburgh, Pa.-based Legend Financial Advisors, a firm that entered the alternative asset arena back in 1994. Today, as many firms are just beginning to venture into commodities and real estate, Legend Advisors is again ahead of the curve, investing, for example, in managed timber.
"Managed timber is a long-term, 20-year lockup investment we use as a proxy for commodities," explains Pearson. "In addition to investing in managed futures, merger arbitrage, and emerging markets money market funds, we're building our own long-short investment."
Of course, one of the challenges in adding alternative investments like timber is the extra due diligence. Legend Advisors' solution was to supplement their investment committee with an intern program. "Right now, we have eight interns," Pearson explains. "They handled the initial research necessary to get into timber and often organize information from the completed questionnaires we get back from mutual fund companies we are considering. Because we're looking for the boutique firms--fund companies that are dedicated to managing money, not just marketing--our evaluations are very lengthy, and it helps to have additional research resources."
In addition to more due diligence, Pearson notes that moving in and out of alternative investments also requires more attention to rebalancing. Here, the firm gets a boost from the software program iRebal. "Last year three advisors spent four to six weeks identifying portfolios that needed to be rebalanced," Pearson notes. "This year with iRebal, one person reviewed all our portfolios in just one day. We'll need to go ahead and make changes in the portfolios he identified, but iRebal has increased our productivity significantly."
At MWBoone & Associates in Bellevue, Wash., Michael Boone, CFP, CFA, stresses his commitment to use "good, solid, managers and recognizable asset classes," and, as choices have increased, he's added some new asset classes, among them commodities and managed futures.
Explains Boone, "We view alternatives like the market does--a little skeptically at first and more accepting as money goes in and scrutiny and regulations increase. We are not the first to jump into a new alternative investment. We don't want to rush into something that will blow up and hurt clients but are always interested in evaluating asset classes with low correlation and some potential for growth."
How does Boone evaluate a new asset class without a long history of returns? "Planners who operate with a computer-driven asset allocation and optimization approach have to know exactly what something will return. We don't use a mean variance optimization program in the technical sense," he explains. "Rather than rely on historical data, we seek to understand what it is that makes the asset class move in the market. If you understand what drives an asset class, then you know where to put it in the portfolio."
While Boone invests in many of the same assets classes found in portfolio satellites, he does not believe in a passive core, seeking instead to add value through active management. "We don't use index funds," he says. "If I gave a planner $2 million and they put $1.5 million in an index fund, I'd say 'I'll take the $1.5 and spend $8 to buy an EFT, and you can manage the $500,000.' An index fund simply ensures that you can't generate alpha on that part of the portfolio and with management fees on the indexed core, the client doesn't achieve the market return."
In fact, Boone's conviction that he manages money only where he can add value sometimes means that clients manage a portion of their portfolio themselves. "If someone is doing good job with a portion of their portfolio, I'll suggest that they continue doing what they do well and let me try to add value in another area of the portfolio," he notes.
A look inward
In spite of the fact that alternative investments are now commonly found in satellites and more traditional portfolios, not everyone is comfortable with them. Al Wroblewski, a CFP in Uxbridge, Mass., feels advisors who abandon traditional stocks and bonds are operating with a false sense of confidence. "The advent of more precise and sophisticated analytical tools does not reduce the high level of risk that is intrinsic in the underlying investment," he says. "The only way you can tweak the asset allocation to generate some extra return is to take on more risk, and that acknowledgement is missing. Nothing is for free."
In Wroblewski's view, a reasonable long-term strategy is simply to participate in the market. If advisors seek to generate something extra, he believes it should be sought not by making major alterations to asset allocation, but by reviewing clients' current financial circumstances in order to help them improve their financial decisions. "Despite all our sophisticated modeling tools, the human decision-making mechanism is so primitive," he says.
Drawing on research related to judgment and decision making by Leonard Lee at MIT suggesting that the values part of the brain is not connected to the immediate behavior part of the brain, Wroblewski's current focus is exploring the disconnect between what clients say they believe and what they do.
Examples like this one offered by Lee in a recent seminar Wroblewski attended illustrate the contradiction between values and behavior:
A group of seminarians at a conference is told an important lecture on the Good Samaritan is about to start in the next building in five minutes. In the alley between the buildings, there is someone pretending to be a homeless man in need of help. Unbelievably, the seminarians jump over the homeless man to get to the lecturer on the Good Samaritan.
"Nobody stopped because their immediate focus was getting to the meeting and that took precedent over their values," Wroblewski comments. "Even though these people had dedicated their lives to helping others, and the experiment in fact exaggerated that commitment by sending them to a lecture on the Good Samaritan, the current reality didn't connect with the values-driven part of the brain."
Applying this disconnect to the to advisors' world, Wroblewski says that results of risk tolerance questionnaires and clients' stated objectives--the foundation for asset allocation decisions--are suspect. "If we can improve on this even a little bit, forge some connection between thought and action, that's where the opportunities are to help clients reach their goals," he says. "Especially considering the increased risk of some alternative investments, it's more beneficial to focus our attention inward than trying to get one more percentage point from the market."
In fact, just such a focus is working well for Evensky who, when he moved from a very active asset allocation to a more passive investment approach, didn't lose a single client. "The move to core and satellite was terrible from a marketing standpoint because no longer could we talk with clients about the time we spent evaluating talent, the new managers we hired, and the ones we fired," Evensky comments. "However, the silver lining has been that because there is so little to talk about from an asset allocation standpoint, we find ourselves talking about what's really important--our clients' lives."
Nancy Opiela is a freelance writer in Medford, Mass., specializing in financial topics.