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OBJECTIVE

“The Place of ETFs in Portfolio Allocation and Diversification” is eligible for CE credits, see Accreditation details for more information

There’s not much new in the world of asset allocation despite the drubbing portfolios sustained last year. Many of the best and the brightest minds, and the most researched and supported techniques, failed to save Humpty Dumpty from shattering on impact.

To be sure, diversification never seems to work when fear and flight take control of a market. But this understanding does little to regain the confidence of clients staring at double-digit losses.

Academics can debate whether the efficient market hypothesis is dead or whether Modern Portfolio Theory needs modernization, but investors want practical answers now. And the first question that must be answered is: Do the pants fit?

Asset allocation is the strategy investors follow to divide their money between different assets like stocks, bonds and cash. The underlying principle is that prices of different assets move in different (uncorrelated) ways, leading to the idea that diversification protects against risk, which is defined as volatility. But asset allocation says little about the investor’s objectives (or pant size).

Psychologist Abraham Maslow is credited with saying “if your only tool is a hammer, every problem looks like a nail.” The phrase applies well to the investment business because advisors too often believe maximizing return is every investor’s goal, all of the time. While it can be argued that conservative, moderate or aggressive risk profiles determine the kinds of investments chosen, these solutions are likely constructed only on perceived risk tolerance not on investor’s needs.

Maslow is best known for his “hierarchy of needs,” and in that context an investor should think of his or her pool of investment capital as a “hierarchy of goals.” These include:

  • Goal 1—covers basic needs such as food, clothing and shelter;
  • Goal 2—covers lifestyle enhancements such as a cottage, vacations, and French rather than Chilean wine; and
  • Goal 3—allows a client to leave a legacy such as paying for the grandchildren’s educations, or philanthropy.

In this context, a typical split may be basic (60%), enhanced lifestyle (25%), and legacy (15%). One can then assign risks to each goal.

The belt approach

Goal 1 is important; the advisor can’t take much risk here. So go with about 80% bonds and 20% equities.

Goal 2 offers more flexibility, perhaps 60% equities and 40% bonds.

Goal 3 has a longer time horizon goal, so go with around 80% equities and 20% bonds.

By weighting each goal based on the investor’s preferences, the final asset mix will better reflect his or her needs. And, regardless of investing methodology, this approach helps investors understand the relationship of their asset mix to needs.

A more sophisticated methodology is to use value-at-risk (VaR).

Ioulia Tretiakova, our director of quantitative strategies, notes that this approach creates a return floor for the portfolio. So, if the investor’s risk number (or VaR) is eight, then an investing time horizon of about eight years is suggested. And, the minimum expected return at the end of that eight-year period will be the return of all capital plus inflation with a 95% historical probability. While this isn’t 100%, it suggests a high confidence level with a return floor. This is possible because risk is persistent.

VaR has gotten a bit of a black eye because similar analysis, abused by Wall Street mortgage bankers, contributed to overconfident assumptions in pricing and selling collateralized debt obligations. We, however, assume an extra margin for error, three standard deviations (SD) versus the 1.6-to-2.0 standard deviations normally used. But during a tsunami risk event like 2008, even this isn’t going to save the portfolio. And that’s why the client also needs suspenders!

Back to braces

Rebalancing to a fixed asset mix (say 60% equities, 40% bonds) is a popular tactic among professional and retail investors alike. It’s simple and intellectually satisfying.

Selling an asset class as it rises to buy others sounds right (sell high/ buy low). Doing this from 1990 to 2001, before and during the technology bubble, meant selling stocks into the run up to maintain a 60:40 mix during the entire period.

Meanwhile, the technology sector’s weight in the S&P 500 Index rose from 8% to more than 30%, and the one-year moving average of S&P volatility rose from 12.5 to more than 15. Was the risk in the market the same at the beginning of the period compared with the peak? Of course it wasn’t. Nevertheless, many investors’ portfolios maintained the same static volatility risk profile throughout (see “Technology and Sector Risk,” below).

Technology and Sector Risk/Risk- Base Asset Allocation graph

Rebalancing to a constant volatility means reducing risk when market volatility rises (sell stocks and buy bonds or cash) and vice versa when it is low or falling.

Fast forward to 2004 (see “Risk- Base Asset Allocation,” left) and we have 12-month volatility low and stable until 2007. The S&P 500 continued to climb during this period and rising volatility provided a good caution signal into 2008.

We set the weight of S&P 500 in a simple equity/cash asset mix to target the constant level of volatility of 15% (the long-term volatility of S&P 500). The target weight of the S&P 500 is calculated as [(target volatility)/(current volatility)]2 (the ratio of variances, hence the ratio is squared).

For example, the most recent 252-day volatility of 45% and target volatility of 15% (long-term level of volatility of S&P 500) result in (0.15/0.45)2 = 11.1%. The rest is allocated to cash earning 3% per annum. The resulting risk-based asset mix beats the S&P 500 by 3.68% per year with just over half the risk.