Reports of Asset Allocation’s Death Are Greatly Exaggerated

Scott Burns, Director, exchange traded securities analysis at Morningstar, consider asset alloca...

Scott Burns, Director, exchange traded securities analysis at Morningstar, consider asset allocation

The title is a play on the understated response by Mark Twain to a newspaper report that he had perished. Many in the press have prematurely put the theory and practice of asset allocation - much like the famous author - in the grave. We don't buy it. Admittedly, 2008 was a terrible year and we've already commented on how many 'truisms' were doused in the wave of bad news and worse returns. Still, the power of diversification and the role of asset allocation in a portfolio were not among them. In fact, we think that the opposite is true. Last year's turmoil only underscored the power of diversification, exposure to multiple asset classes and rebalancing.

Realistic expectations

I've been on the conference circuit lately speaking on panels and giving instructional seminars on ETFs and portfolio management. It has been an eye-opening experience for me in terms of understanding investor sentiment. The most frequent question posed to me is: "Is there an ETF out there that has a really high dividend yield, great growth prospects, and won't ever go down (low risk)?" The answer is a resounding no! That investment has never existed, nor will it ever. Risk always equals return in the end. Just because you bought something with a high yield or strong growth prospects that increased in value doesn't mean it was without risk. You just chose well and your risk-taking paid off.

This experience has put the whole Bernie Madoff scandal in perspective. When the story of his pyramid scheme first broke, I wondered how so many people could have fallen for it. Not to clear Madoff of his horrid malfeasance, but many of his investors were willfully ignorant accomplices in this deceit. Their desire to find the easy money and cheat the system left them either consciously or unconsciously blind to the fact that they were asking for the impossible. Worse, even after all the light the Madoff scandal shined on the impossibility of the existence of these high-returning risk-less investments, people continue their futile search for the magic bullet.

The expectations for asset allocation portrayed in the press have been no less unrealistic. Asset allocation aims only to reduce risk and maximise return over the long run versus the alternative of holding individual securities. The key word is 'reduce'. Never in the past 75 years did asset allocation remove the risk of investing. To do so would be to remove the possibility of return.

Readers need to re-examine their risk tolerances and see how much volatility they can stomach or, more importantly, how much capital they can risk losing.

On correlation

There's an old adage that in a bear market the only thing that goes up is the correlations. In fact, most of the arguments regarding the demise of asset allocation have revolved around the fact that equity markets of all styles, sectors and geographies dropped - providing little relief through diversification. But a truly diversified portfolio contains not just equities, but also bonds, commodities and real estate. In fact, Treasury bonds in particular showed negative correlation with the equity markets. I think the surprise stems from the fact that the negative correlations didn't come from the usual sources: commodities and real estate. The reason is simple: this is the first deflationary bear market the US has experienced since 1954. The rest have been inflationary in nature. In an inflationary environment, it is commodities and real estate that provide the portfolio ballast and Treasuries that underperform.

Let's look at a simple portfolio with 60% of assets in SPDRs SPY and 40% in iShares Barclays 7-10 Year Treasury IEF. SPDRs was down 39.5% in 2008 and IEF was up 19%. In this sample portfolio, the 2008 return would have been 216%. That's not great, but it's better than double SPDRs by itself.

Now, let's consider that we held this portfolio from 2004 thru 2008 (five years) and did a simple rebalance back to 60/40 at the end of every year. If we started out with $100,000 we would have $113,000 at the end of 2008. If we had held just SPDRs through that period we would have only $86,000 in our portfolio today. What if we had been ultraconservative and held just IEF the entire five years? We would have ended 2008 with $145,000 in our pockets. Of course, at the end of 2007, we would have been kicking ourselves because we would have been lagging a portfolio of just SPDRs by more than $20,000.

Of course, this example is handicapped by the fact that we have chosen one of the worst-ever years for the stock market (and conversely one of the best years ever for Treasury bonds) as our end point. But the investing timeline is far from over. Calling asset allocation dead in 2009 would be analogous to us saying it was dead at the end of 1974. That year, the S&P 500 dropped 47% and correlations across the equity board rose to one. The reality was that adherents of a balanced portfolio discipline sold their bonds and commodities, bought stocks low and enjoyed one of greatest and longest stock market rallies of the 20th century.

Rebalancing 101

Remember, the whole point of asset allocation is to maximise return while reducing risk. The first part of this mission is to create an efficient portfolio.

The other tool in the asset-allocation arsenal is rebalancing. Rebalancing is essentially the discipline of adhering to those original allocations over the
long run. Given that a portfolio is a closed-loop system and that all the holdings must add up to 100%, if one holding strays too far from its allotted allocation, then at least one other has likewise strayed. So, there is no rebal-ancing of just one single holding.

When we rebalance we are doing one of two things. When stock values are rising we are essentially locking in gains by taking money off the table. This means that we are selling our winners and deploying them into sectors that didn't perform as well. When the stock market is falling, this means that we are selling some of those locked-in gains to buy stocks on the cheap.

The question of when to rebalance has drawn a lot of attention recently from both academic and professional circles. Some say to do it at least twice a year to keep yourself as close to your model portfolio as possible. Others say that it is better to rebalance every two years, because more frequent rebalancing truncates the effects of momentum in the various asset classes.

The last thing to keep in mind is transaction costs. As great as ETFs are, transaction costs can cause drag - especially if you are moving small amounts of money. My advice is to use common sense during rebalancing. If you are looking at selling only $100 of a position with a $10 transaction fee, don't do it! This is essentially creating a 10% return hurdle that the security needs to meet just to get you back to the break-even point. It is okay for your position to stray a few percentage points if the alternative is to hand your broker money for nothing.