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The Importance of Asset Allocation How Baird Approaches Portfolio Design by Baird Asset Manager Research

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The Importance of Asset Allocation How Baird Approaches Portfolio Design by Baird Asset Manager Research The Importance of Asset Allocation How Baird Approaches Portfolio Design By Baird Asset Manager Research Summary Asset allocation establishes the framework of an investor’s portfolio and sets forth a plan of specifically identifying where to invest one’s money. Advocates conclude that proper asset allocation has the potential to increase investment results and lower overall portfolio volatility. Critics argue that the interconnectedness of financial markets makes traditional asset allocation less beneficial. It is Baird’s opinion that both are correct – asset allocation can lead to better overall results, but the implementation needs to be flexible enough to adapt to longer- term trends in the market. In this paper we seek to answer: • Why asset allocation is still one of the most important strategies an investor can employ. • Why asset allocation and diversification should be addressed concurrently but thought of separately. • How Baird views this subject and how our asset allocation models are derived. The Value of Asset Allocation Asset allocation is important in two distinct ways. The first is from a portfolio design standpoint. The theory asserts that in any given period, some investment styles will be winners and some will be losers, and this varies over time. The addition of investment styles that perform differently than the rest of your portfolio (i.e., have a low correlation) can reduce overall portfolio volatility. This is because individual asset classes can be volatile, but in a well-constructed portfolio, there will while the benchmark rose 9.2%. In be other investments that partially other words, most investors missed offset that volatility, both on the nearly half the positive market upside and downside, thus producing performance by trying to time when a more stable return pattern. to buy and when to sell. Moreover, despite being in a higher performance The second reason asset allocation is asset class, stock investors were barely important is that it helps investors able to keep pace with inflation. keep a long-term perspective and This underperformance is even more avoid knee-jerk reactions. Investors prevalent when examining bond have a tendency to chase the best- investors, who have dramatically trailed performing segments of the market inflation and the broad bond market. GRAPH 1: Step 1: Asset Allocation Performance of the Average Investor The general approach of an asset 10% 9.2% allocation strategy is to determine which asset classes to invest in based 8% 7.7% on your risk tolerance and return objectives. It is our opinion that any 6% 5.0% portfolio implementation decisions 4% must separate two important 2.8% concepts: asset allocation and 20-Year Annualized Return Annualized 20-Year 2% diversification. Asset allocation in its 0.7% most basic form is the decision of how 0% to weight stocks, bonds and cash in a Avg Stock Avg Bond Stock Index Bond Index Ination Investor Investor (S&P 500) (BC Agg) (CPI) portfolio in a way that provides the potential for the best investment Source: Dalbar, for the 20-year period ending 12/31/13. Please refer to page 7 for information. return for the amount of risk you’re willing to accept. Setting these targets and shun poor-performing areas. Yet, appropriately is a critical first step it is incredibly difficult to guess what in portfolio construction. Too much areas will continue to shine and what in bonds or cash will ensure lower the next market leaders will be. Trying volatility than stocks, but may not to time the market can have perverse produce enough returns to meet consequences, which are illustrated return objectives or keep ahead of in a study conducted by Dalbar inflation. Conversely, too heavy a Associates (Graph 1) that shows that weighting in stocks can produce stock investors over the past 20 years higher rates of return over time, but averaged a 5.0% annualized return can also be subject to large swings in value over shorter periods. - 2 - Expected return and acceptable risk Step 2: Diversification must be viewed simultaneously – an The first step lays the foundation for investor must feel comfortable with the how a portfolio is to be structured. downside risk associated with higher The second step, diversification, involves return potential. Graph 2 illustrates how spreading your assets around to various an increased stock allocation leads to the investment types. The goal is to potential for larger positive returns over construct a portfolio that has exposure a 12-month period, but also the to many different areas, some of which 1 possibility of larger negative returns. perform independently of the others. While an all-stock portfolio may provide By properly diversifying a portfolio, it the highest average returns over a is possible to achieve higher expected 12-month period (21.8%), it also returns and lower overall volatility. exhibits the largest average loss (13.6%). Conversely, following an all-bond Diversification works best when asset approach has historically had limited classes have low correlations with one downside (only 15% of the periods another – when some zig, the others studied showed negative returns), but zag. Historically, this was achieved in produced less than half the positive a relatively simple manner. Expanding returns of the all-stock approach. a large-cap, U.S.-based stock portfolio Identifying the upside and downside to include small-cap or international thresholds that an investor is stocks would have provided sufficient comfortable with is an important diversification. Over the past 10 years, step in ensuring that the asset however, the financial marketplace has allocation plan has staying power. become increasingly interconnected GRAPH 2: The Relationship Between Upside and Downside Potential Avg. Negative Return Avg. Positive Return % Positive Periods % Negative Periods 100% Stocks / 0% Bonds (13.6) 21.8 72% 28% 80% Stocks / 20% Bonds (10.4) 18.4 74% 26% 60% Stocks / 40% Bonds (7.9) 14.7 77% 23% 40% Stocks / 60% Bonds (6.1) 11.0 84% 16% 20% Stocks / 80% Bonds (3.1) 8.5 87% 13% 0% Stocks / 100% Bonds (2.4) 7.3 85% 15% 100% Cash 3.5 100% 0% -20 -15 -10 -5 0 5 10 15 20 25 Average 12-month Return (%) Source: Baird Research, Standard & Poor’s, Barclays Capital, Citigroup. For the December 31, 1926 to December 31, 2013 period. Stocks are represented by the S&P 500 Index and bonds by a 50/50 mix of the IA LT Corporate and IA IT Treasury indices rebalanced monthly. The IA (Ibbotson Associates) bond indices measure the performance of U.S. government and corporate bonds with maturi- ties less than 10 years. See appendix for more information. - 3 - and highly correlated. One needs only to How Baird Approaches look at the dismal 2008 returns of many Asset Allocation asset classes to be reminded how At Baird, providing sound advice for similarly different types of investments our clients is our top priority, and we move in times of turmoil. feel that asset allocation provides the Figure 1 provides various examples of framework of any investment strategy; how a portfolio can be diversified using therefore, a significant amount of time more traditional and alternative and resources are dedicated to this topic. methods. While including less To that end, Baird’s Investment Policy Committee is charged with the task of commonly used asset classes does not preparing model asset allocation necessarily lead to a diversified portfolio, portfolios that can be used by a variety Baird believes that asset allocation and of clients. This committee consists of diversification strategies need to be various leaders throughout the flexible and accommodate both organization, with input from Baird’s traditional and alternative methods. FIGURE 1: Chief Investment Strategist and the The Various Degrees of Asset Allocation financial planning, research and asset management departments. We currently Basic Asset Traditional Expanded have six distinct models that are Allocation Asset Allocation Investments designed to offer a continuum of risk U.S. Stocks U.S. Large-Cap Stocks Alternative Mutual Funds and return characteristics (Table 1). Treasury Bonds U.S. Small-/Mid-Cap Stocks Structured Products It is important to note that these models Cash International Stocks Managed Futures are strategic, not tactical. Strategic Satellite Asset Classes Hedge Funds models are meant to take a long-term Growth and Value Styles Private Equity U.S. Corporate Bonds view of investing, whereas tactical U.S. Municipal Bonds models shift allocations based on perceived opportunities in the market. It is Baird’s belief that the core of a portfolio should adhere to a long-term TABLE 1: strategic asset allocation plan with Baird’s Strategic Model Portfolios* Capital Conservative Income with Growth with Capital All Asset Class Preservation Income Growth Income Growth Growth Large-Cap Value — 7.25% 9.25% 14.00% 16.75% 20.00% Large-Cap Growth — 6.25% 8.00% 12.00% 14.25% 16.75% Mid-Cap Equity — 2.00% 5.00% 8.50% 12.50% 15.50% Small-Cap Equity — — 2.00% 3.50% 5.50% 7.25% International — 4.50% 7.75% 14.00% 21.00% 27.50% Satellite — — 8.00% 8.00% 10.00% 10.00% Intermediate Fixed Income 50.00% 40.00% 35.00% 25.00% 11.50% — Short-Term Fixed Income 30.00% 25.00% 15.00% 11.00% 5.50% — Cash 20.00% 15.00% 10.00% 4.00% 3.00% 3.00% Absolute Return — — — (Optional 20%) (Optional 15%) (Optional 10%) *As of December 2013. Asset classes and weightings are subject to change. - 4 - tactical shifts made on a client-by-client growing area of investment with Asset Allocation in Uncertain Times basis. That being said, the committee does options that have low correlation to review new investment ideas regularly and equity and fixed income markets A proper asset allocation plan will make revisions to the models as provides a long-term framework to When used in isolation, some of structure a portfolio.
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