Posted by: STEVE ARNETT
Posted on: April 9, 2012
Today, if you ask an informed investor what asset allocation is, he might say it is a way of diversifying investments among different asset classes like stocks, bonds, and cash in order to control downside risk and maximize upside return. Or he might say asset allocation prevents “putting all of your eggs in one basket” or “not betting the farm on it.” In other words, it’s a pretty simple concept that should have been obvious to everyone.
Surprisingly, it was just a little more than 25 years ago that asset allocation was first discussed. By this time, we had already been to the moon six times, Post-It® notes had been invented, and Fuji had created the first disposable camera. It was in a 1986 article published in Financial Analyst Journal, “Determinants of Portfolio Performance,” by Brinson, Hood, and Beebower that asset allocation was first discussed. Using data from 91 large pension funds measured from 1974 to 1983, the most significant finding was that a portfolio’s asset allocation is the primary determinant of portfolio return variability (93%), with security selection and markettiming accounting for the balance. Many investors have misinterpreted their findings to mean “return” rather than the “variability of returns” that are determined by the asset allocation. It was out of frustration that this research was undertaken, because institutional firms that invested millions of investors’ dollars were myopic when it came to managing monies; they were solely focused on security selection, and asset allocation was just an afterthought. A byproduct of the paper was that the pension funds’ average returns were unable to outperform the indexes that had been used as proxies for the pension funds asset classes.
By contrast, asset allocation is the cornerstone of today’s investment strategy and has evolved beyond the paper’s original asset classes of stock, bonds, and cash to include real estate, commodities, and alternative investments. The expansion of asset classes was borne from an effort to find classes with low correlations to each other, with the goal of smoothing investment performance with a balance of classes that perform in a countercyclical fashion (i.e., when one asset “zigged” another one “zagged”).
With baseball season starting in full swing, Babe Ruth’s hitting style may be a helpful analogy; he was going to hit a homerun or strike out. In investment terms, he might be considered an aggressive growth manager. To complement his style, the team would need a lead-off hitter like Pete Rose who had a high probability of getting on base. So if Ruth hit a homerun, there was a high probability that Rose would be on base, yielding two runs rather than one. If he struck out, Rose was still on base with the ability to score. In investment terms, Rose might be viewed as a blue chip stock. So it is up to the manager to create a lineup of players whose styles will complement each other because a team of just Ruths or just Roses would be one-dimensional and probably would not take you to the end game.
But at the same time, the lineup can’t be static. There are times when the team is not performing and a change in the lineup is necessary. In this case it might mean putting a different person in the lineup or maybe trading for one who will improve performance. In the investment world this might mean putting a portfolio manager on probation or even terminating him. It is common for a team facing a left-handed pitcher to load the lineup with right-handed batters. From an investment standpoint, this might be a decision to increase an allocation to the large cap portion of the portfolio because it looks very attractive. A manager might find that he is weak in several positions and the team superstar hasn’t been performing up to his $100 million contract. There may be an opportunity to trade him for five players who the manager believes have more upside potential. In this case it is the equivalent of selling high and buying low.
One success story in the mutual fund lineup is Vanguard, now one of the most recognized names in mutual fund families but which was originally started by someone down on his luck. In 1974, Vanguard was founded by John Bogle, who had been president of Wellington Management but was fired by his four partners. Vanguard came into existence, initially providing record keeping services for the Wellington funds. Bogle recalls:
Its initial public offering in the summer of 1976 raised a puny $11 million, and early growth was slow. Assets of First Index (subsequently changed to S&P 500 Index) didn’t top $100 million until six years later, and only because we merged another Vanguard actively managed fund with it. But the coming of the Great Bull Market that began in mid-1982 started the momentum, and the fund’s assets crossed the $500 million mark in 1986.
Since that time, assets under management have exploded to $1.7 trillion and Vanguard is today’s leader in low cost mutual funds.
As the Brinson study observed, much of the difference in performance between index funds and pension funds was attributable to fees. Here at The Trust Company, historically we have utilized only active management but began incorporating index funds several years ago. The first step was our termination of Wells Fargo, which had managed our Large Cap Growth space, followed by a replacement of Mainstay Large Cap Growth and Vanguard Growth index; more recently we’ve used Vanguard indexes to manage part of our Large Cap Value and all of our Mid Cap Value space. As of March 31st, we had an index allocation of 23.25% and 18.50% in our Stock and Aggressive Stock portfolios, respectively. We anticipate their exposure in our portfolios will increase over time. We have no plans to make any changes in our bond portfolios because we believe that active management will perform better when rates eventually go up.
We have been getting a lot of questions about commodities. How do they work and should we add them to our portfolio? To address those questions, within our stock model, we have more than 5% ownership in some of the largest commodity companies in the world. A couple of names that you might recognize are BHP Billiton PLC (the largest silver-producing company in the world) and Monsanto Company (a world leader in agricultural biotechnology). Let’s discuss what a commodity is and what its attributes are. Examples of commodities are livestock, agriculture, precious metals, industrial metals, and energy. The largest component in the two main commodity indexes, the S&P 500 GSCI and the DJ/UBS Commodity Index, is energy, which composes 66.5% and 31.8%, respectively, of the indexes’ commodity classes. Factors that influence commodity prices include constrained supply or the fear of further limitations on supply as a result of geopolitical turmoil. An example of a factor affecting supply would be the further increase of demand caused by modernization and industrialization in China and India. In the case of geopolitical turmoil, examples might include the overthrow of Gaddafi or the threat of an airstrike by Israel on Iranian nuclear facilities. Generally speaking, commodities perform well in a low and rising inflation (less than the median of 3.4%) environment, which is what we are presently experiencing. Since 1971, there have been just seven occurrences of such environments. During these periods, stocks, bonds, cash, and commodities have generated returns of 20%, 6%, 3%, and 22%, respectively. While we do have current exposure to commodities through our current managers, we continue to monitor the opportunity to add direct exposure through a commodity strategy. We are cautiously optimistic. The economy continues to move along in a steady pace, albeit at less than what we would like. Inflation is present but we don’t believe it is at the point of taking off. Our exports are up and there are rumblings that some of the jobs that were offshored are coming back to the US. The first quarter has been a very calm period considering all of the volatility we experienced in 2011. Many times the catalyst for increased volatility comes from unexpected events, such as the depth of the European problems and the downgrade of US debt. Gas prices have moved to the forefront of economic concern with the Israel and Iran situation flaring up in the first quarter.
For the quarter ending March 31, 2012, returns for the S&P 500, NASDAQ, Russell 2000, MCSI EAFE, and Barclays U.S. Aggregate Bond indexes were 12.59%, 18.67%, 12.44%, 10.86%, and 0.31%, respectively. For the same period, our Stock, Aggressive Stock, Balanced, and Fixed portfolio returns were 12.55%, 12.99%, 8.29%, and 4.02% respectively.