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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 to specifically identify 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 8.2%. be other investments that partially In other words, most investors offset that volatility, both on the missed 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 performing 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% allocation strategy is to determine 8.2% which asset classes to invest in based 8% on your risk tolerance and return 6% 5.3% objectives. It is our opinion that any 4.7% portfolio implementation decisions 4% must separate two important concepts: 2.2% asset allocation and diversification. 20-Year Annualized Return Annualized 20-Year 2% Asset allocation in its most basic form 0.5% is the decision of how to weight stocks, 0% bonds and cash in a portfolio in a way Avg Stock Avg Bond Stock Index Bond Index Inflation Investor Investor (S&P 500) (BC Agg) (CPI) that provides the potential for the best investment return for the amount of Source: Dalbar, for the 20-year period ending 12/31/15. Please refer to page 7 for information. risk you’re willing to accept. Setting these targets appropriately is a critical and shun poor-performing areas. Yet, first step in portfolio construction. it is incredibly difficult to guess what Too much in bonds or cash will areas will continue to shine and what ensure lower volatility than stocks, the next market leaders will be. Trying but may not produce enough to meet to time the market can have perverse return objectives or keep ahead of consequences, which are illustrated inflation. Conversely, too heavy a in a study conducted by Dalbar weighting in stocks can produce Associates (Graph 1) that shows that higher rates of return over time, but stock investors over the past 20 years can also result in large swings in averaged a 4.6% annualized return 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 possibility of larger negative returns.1 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 (21.3%), 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 nearly a third of 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 Average 12-month Return Standard Deviation % Positive Periods 12.0% 20.1% 73% 100% Stocks / 0% Bonds (13.6) 21.3 10.7% 16.2% 74% 80% Stocks / 20% Bonds (10.4) 17.9 9.4% 12.6% 78% 60% Stocks / 40% Bonds (7.9) 14.4 8.2% 9.3% 84% 40% Stocks / 60% Bonds (6.1) 10.8 7.0% 7.1% 88% 20% Stocks / 80% Bonds (3.1) 8.4 5.8% 6.8% 85% 0% Stocks / 100% Bonds (2.4) 7.2 3.5% 3.1% 100% 100% Cash 3.6 -20 -15 -10 -5 0 5 10 15 20 25 Average 12-month Return (%) Source: Baird research, Standard and Poor’s, Barclays, Citigroup. For the years ranging December 31, 1926 to December 31, 2016. Stocks are represented by the S&P 500 Index and bonds by a 50/50 mix of the IA LT Corporate and IA ITTreasury rebalanced monthly. The S&P 500 Index is a well-known gauge of stock market movements determined by the weighted capitalization of the 500 leading U.S. common stocks. The Ibbotson Associates (IA) bond indices measure the performance of U.S. gov’t and corporate bonds with maturities greater than ten years. These allocations are rebalanced annually. Indices are unmanaged and are not available for direct investment. Indices are unmanaged and are not available for direct investment. Past performance is not a guarantee of future results. - 3 - and highly correlated. One needs only How Baird Approaches to look at the dismal 2008 returns of Asset Allocation many 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 methods. and resources are dedicated to this topic. While including less commonly used To that end, Baird’s Investment Policy Committee is charged with the task of asset classes does not necessarily lead preparing model asset allocation to a diversified portfolio, Baird believes portfolios that can be used by a variety that asset allocation and diversification of clients. This committee consists of strategies need to be flexible and various leaders throughout the accommodate both traditional and organization, with input from Baird’s 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 20%) (Optional 10%) Diversified Yield — — (Optional 20%) (Optional 20%) — — *As of September 2016.
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