Focus on a Critical Source of Return Variability

Focus on a critical source of return variability : Asset allocation accounts for most of the variability (that is, risk) in a portfolio’s long-term returns. A well known (and often misinterpreted) 1986 study by Gary Brinson, Gilbert Beebower, and Randolph Hood concluded that the SAA selected accounted for 93.6% of the variation in quarterly returns on very large investment portfolios over long time horizons. Over the years, this conclusion has been mistakenly interpreted to mean that 94% of the difference in the return between portfolios is accounted for by the difference in their SAAs, or that 94% of a portfolio’s return is accounted for by its SAA. But the study did not address either of these issues. A 2000 study by Roger Ibbotson and Paul Kaplan re-examined asset allocation and tried to clear up some of the confusion surrounding the conclusions of the BBH study. Using 10-year compound annual total returns for a sample of pension funds and mutual funds, Ibbotson and Kaplan came to a conclusion similar to that of BBH: SAA accounts for about 90% of the variability of a portfolio’s returns over time. However, they found that a fund’s SAA accounted for only 40% of the return variation among funds. That is, the different SAAs of the funds accounted for only 40% of the variability in their returns. The other 60% was attributed to tactical asset allocation, security selection, and fees. The study also concluded that SAA accounted for about 100% of the level of a fund’s return. As this study clearly shows, the actual contribution of SAA to a portfolio’s performance depends on how the performance question is framed. Although asset allocation is not the only infl uence on the variability of long-term returns, it strongly affects a portfolio’s long-term risk and return. Designing appropriate SAAs is therefore vital in helping clients meet their investment objectives and risk tolerance. 2. An efficient investment portfolio : An appropriate SAA represents an effi cient investment portfolio. As noted in Chapter 11, an efficient portfolio has the greatest expected return for the level of risk incurred. The goal of SAA is to fi nd an effi cient combination of asset classes that will achieve the client’s return and risk objectives. 3. Meaningful performance measurement : Without a clear SAA, it is diffi cult to set goals or measure progress against those goals. For example, an SAA of 5% cash, 35% debt securities, and 60% equities allows for performance comparisons against a “benchmark” portfolio of similarly weighted money market, bond, and stock indexes. The SAA also allows for meaningful performance attribution, which means analyzing the sources of portfolio performance and explaining returns in terms of the relative contributions of asset allocation and security selection. SAA and performance attribution can also be used to assess the results of TAA strategies. A successful TAA strategy would outperform the SAA benchmark, whereas an unsuccessful TAA strategy would underperform it. 4. Investment discipline : A properly structured asset allocation strategy imposes discipline on the investment process in two ways. First, and most importantly, the rebalancing strategy ensures that the portfolio continues to reflect the policy and design of the original SAA and the client’s long-term investment objectives. Second, the SAA helps advisors and clients decide whether to add new asset classes or securities to the portfolio. For example, a conservatively structured SAA suggests caution is warranted before introducing a new volatile asset class to the mix. 5. Tactical flexibility to enhance returns : TAA can enhance returns through successful “tilts” away from the SAA. (Note that, as is the case with any active investment strategy, TAA is not always successful.)

There are four key benefits of a rebalancing strategy: 1. Risk reduction : If a portfolio is seldom or never rebalanced, the result is higher portfolio volatility. For example, if equities perform better than expected, over time the percentage of the portfolio invested in equities will increase. This increased exposure to equities leads to greater portfolio risk. Rebalancing ensures that the optimal balance between risk and return is maintained. 2. Performance improvement : Some research supports frequent rebalancing as return-enhancing; other research does not. In general, less frequent rebalancing enhances performance in less volatile markets and more frequent rebalancing improves returns in very volatile markets. No specific rebalancing approach is best for all markets and all portfolios. However, research does show that rebalancing by itself adds to total returns over extended periods of time compared to allowing the portfolio to drift. 3. Discipline : Without a rebalancing strategy, portfolio drift can become an active “bet” on market direction. Rebalancing forces advisors and clients to stick to the agreed-upon policy during unfavourable or emotionally charged periods. 4. Simplified investment process : Rebalancing provides a clear strategy for restructuring the portfolio following deposits and withdrawals (assuming the client’s circumstances and capital market expectations have not changed). Investment limits established in the SAA provide a framework for investment decisions and reduce the tendency to “time” or postpone investments.

Treynor and Black developed an optimizing model for portfolio managers who use security analysis. It represents a portfolio management theory that assumes security markets are nearly efficient in the context of the single-index model. The essence of the model is this: 1. Security analysts in an active investment management organization can analyze in depth only a relatively small number of stocks out of the entire universe of securities. The securities not analyzed are assumed to be fairly priced. 2. For the purpose of efficient diversification, the market index portfolio is the baseline portfolio, which the model treats as the passive portfolio. 3. The macro forecasting unit of the investment management firm provides forecasts of the expected rate of return and variance of the passive (market index) portfolio. 4. The objective of security analysis is to form an active portfolio of a necessarily limited number of securities. Perceived nonzero alphas of the analyzed securities are what guide the composition of this active portfolio. 5. Analysts follow several steps to make up the active portfolio and evaluate its expected performance: a. Estimate the beta of each analyzed security and its residual risk. From the beta and the macro forecast, E(rM) - rf , determine the required rate of return of the security. b. Given the degree of mispricing of each security, determine its expected return and expected abnormal return (alpha). c. Calculate the cost of less than full diversification. The nonsystematic risk of the mispriced stock, the variance of the

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