I&WM Janfeb011 Blueline.Indd

FEATURE

Asset Allocation and Manager Selection Adaptive Allocation

By Anthony B. Davidow, CIMA®

he market dislocation of 2008 FIGURE 1: STANDARD DEVIATION has led to much debate about T whether asset allocation is still a valid approach to investment. Some Effficient Frontier

discount the merits of modern portfolio RN U theory1 because all correlations tend to Tangency Portfolio go to 1.0 during times of extreme duress.

Mohamed El-Erian, co-chief investment TED RET C Individual Assets offi cer of PIMCO, argues that a “new 2 XPE normal” exists and demands that E investors spend more time evaluating tail risk.3 Th is paper considers the following: Risk-free rate • Is asset allocation still valid? Best possible CAL • Should investors be more tactical? STTANDARD DEVIAATION • What is the new normal? Source: The (Markowitz) effi cient frontier Graphics Reference: http://en.wikipedia.org/wiki/Modern_portfolio_theory • Is it active versus passive, or active and passive? • What are the practical implications into account the amount of risk taken tions between large and small capital- of these changes? and the time value of money. ization; value and growth; domestic and Figure 1 shows the effi cient frontier, international; developed and emerging Historical Perspective which represents the optimal blend of markets; and traditional and alternative In June 1952, a 25-year-old gradu- asset classes (i.e., the optimal risk-return investments (see fi gure 2). ate student named Harry Markowitz trade off ). Th e capital allocation line As the array of asset classes has published a paper titled “Portfolio (CAL) is a line created in a graph of the expanded, investors have struggled to Selection” in the Journal of Finance. It expected returns of all possible combi- determine appropriate weightings for received little notoriety at the time, but nations of risky and risk-free assets. Th e each asset class. A number of com- it is the root of modern portfolio theory tangency portfolio is the portfolio on the mercial and proprietary asset allocation (MPT) and it helped him win the Nobel effi cient frontier with the highest Sharpe models are available, but they are driven Memorial Prize in Economics in 1990. ratio that off ers a greater return for a largely by historical data that introduce Markowitz (1952) discussed risk given amount of risk. biases. Most asset allocation models management through diversifi cation. Brinson et al. (1986) evaluated the use mean-variance optimization as a He suggested that by constructing impact of asset allocation policy deci- primary methodology. Mean-variance a portfolio of two risky investments sions. Th is is an often-cited (but often optimization exploits the risk, return, and that have low historical correlation, an misunderstood) study that suggests that correlation characteristics across multiple investor could reduce overall portfolio “ . . . greater than 90% of a portfolio’s asset classes, and it generally assumes that risk. While this diversifi cation seems change in returns over time is attributable future results will refl ect historical norms. very practical today, it was cutting-edge to asset allocation policy.” Interestingly, at the time. Building on Markowitz’s Brinson et al. (1986) studied the impact of Asset Allocation Today work, Sharpe (1964) took MPT to the stocks, bonds, and cash as the only assets In recent years, considerably more at- next level and introduced the capital available in allocation decisions. tention has been paid to tactical asset asset pricing model (CAPM), which allocation, which overweights or under- describes the relationship between Historical Asset Class Decisions weights asset classes based on forward- risk and expected return and intro- Asset allocation decisions have evolved looking views. Th is is not to be con- duces beta as a measure of market risk. beyond merely stocks, bonds, and cash fused with market timing. Tactical asset CAPM prices risky securities taking (Brinson et al. 1986) to include distinc- allocation decisions can allow investors

FIGURE 2: ASSET ALLOCATION—1986 AND 2010 landscape. In theory, the free fl ow of information should level the playing fi eld Asset Allocation 1986 Asset Allocation 2010 and lead to more-effi cient markets. Th e unintended consequence may be more panic and more rash behavior as information is readily available but not always properly analyzed. For example, the extraordinary growth of hedge funds has led to high-velocity trading that seeks to arbitrage away any pricing disparities. Figure 2 is for illustrative purposes only and is not intended as investment advice, nor do they depict any actual So markets are diff erent today. investment allocations. Investors need to adapt and asset allocation needs to evolve. TABLE 1: SAMPLE ASSET short-term shifts in strategy. ALLOCATION FRAMEWORK Th e key to making good calls and Manager Selection Strategic Tactical appropriately deploying capital depends Asset allocation has evolved over the Equity: 37 35 on one’s access to and understand- years, and so have the ways investors U.S. 25 22 ing of information. With the speed in gain exposure to markets. Investors which information is disseminated via used to merely seek a mutual fund that International 10 10 the media, it is diffi cult for the average described itself in a particular manner. Emerging 23investor to process and respond to this But many mutual funds have tended to Markets information in a timely fashion, and drift as styles move in and out of favor. Fixed: 37 35 more importantly, as quickly as needed. Investment professionals also have Investment 25 25 During extreme events (like the 2008 often avoided investment managers Grade fi nancial meltdown), market correla- who drift from value to growth, or up Global 10 5 tions tend to go toward 1.0 (i.e., most and down the capitalization spec- High Yield 2 5 markets move in unison). Th ese events trum. Th ey seek “style pure” manag- Alternatives: 20 24 remind us that markets aren’t rational ers for asset allocation purposes. Hedge Funds 10 12 (even though over longer intervals they Unfortunately, many style-pure manag- Real Estate 3 2 tend toward normalcy). ers end up delivering market-like results Private because of limitations on the types of 22 Equity The New Normal investments that fi t their disciplines. Commodities 2 5 El-Erian’s “new normal” suggests that Managers limited in where they can Inflation- asset allocation decisions need to be invest often look and perform much like 33 Hedged more adaptive or tactical. But are things the index. Th e growth of index-based Cash: 66really diff erent now? Let’s compare to- strategies has spurred the debate over TOTAL 100 100 day’s environment relative to the market “active” and “passive” investments. Table 1 is for illustrative purposes only and is not in 1990, when Markowitz and Sharpe Figure 3 shows that it is very diffi cult intended as investment advice, nor does it depict to consistently outperform the bench- any actual investment allocations. won their Nobel prizes. Investment options have grown in mark. A manager may outperform one the past two decades, and so has the year then dramatically underperform to respond more quickly to funda- complexity of investment instruments. the next. mental or technical factors driving the Investing has gone global, companies Investment professionals evaluate markets. Tactical calls allow investors to now have global strategies, and many individual manager results, but—per- deploy capital more effi ciently and can seek to capitalize on growth in less-devel- haps more importantly—they evalu- signal either the need for investors to oped markets. We have moved beyond ate how multiple managers perform gain/increase or reduce/avoid expo- basic stocks and bonds purchased by together. In other words, investment sure to an asset class. Table 1 provides institutions and well-heeled investors to professionals emphasize the value of an illustration of strategic and tactical a global environment with participants of combining managers in such a way asset allocation frameworks. Strategic all sizes and all levels of sophistication. as to deliver favorable risk-return asset allocation guidelines are long term Information fl ow also may be con- characteristics.4 Investment profession- in nature, and tactical changes refl ect tributing to the changing investment als will seek managers who exhibit low

January/February 2011 13

correlation to one another, i.e., who FIGURE 3: MANAGER A, B, AND C VS. ZEPHYR LARGE-CAP GROWTH IN perform and react diff erently in various QUARTERLY UNIVERSE RANKING market conditions. To conduct this type of analysis eff ectively, an investment January 1, 2005 - December 31, 2009 (not annualized if less than 1 year) professional must analyze performance 0% data and holdings of each manager. Will the manager perform in the 25% future as in the past? Clearly this is a Manager A judgment call. To further complicate Manager B Manager C matters, traditional manager search Median Russell 1000 Growth tools don’t account for tax impacts, 5th to 25th Percentile Return Rank 25th Percentile to Median which should be a big consideration Median to 75th Percentile for taxable investors because taxes can 75% 75th to 95th Percentile dramatically erode gross returns. Malkiel (1973) argues that the 100% market is effi cient and that the aver- 1 year 3 years 5 years age investor likely will fail to beat the market with any consistency. Ironically, Source: Zephyr Figure 3 is for illustrative purposes only and is neither intended as investment advice nor a recommendation or in 1973 an average investor seeking offer of any specifi c security or strategy. passive exposure was largely out of luck. Today, however, hundreds of exchange- traded funds (ETFs) off er exposure to exchange-traded notes (ETNs). Figure 4 interest in active ETFs, which allow virtually every slice of the market. shows the tremendous growth in the for active management within an ETF Investors need to consider how best number of ETFs and the types of structure.) to gain exposure to particular asset strategies packaged in ETF structures. ETFs are valuable asset allocation classes. Th ey may consider separately Th e fi rst ETF products were designed to tools for implementing tactical deci- managed accounts (SMAs), mutual off er passive exposure to the broad- sions. More advisors are adopting ETFs funds, ETFs, or limited partnerships. based market sectors. Today, ETFs are as a primary way to gain asset class Each has pros and cons. designed to provide exposure to the exposure. If asset allocation remains the Asset allocation has evolved beyond broad-based equity markets, country most important investment decision, merely stocks, bonds, and cash as baskets, sectors, commodities, fi xed then ETFs are the tools for implement- addressed by Brinson et al. (1986). income, and alternative investments. ing those decisions. Investors now consider allocations into Institutions, family offi ces, and fi nancial But not all ETFs are created equal. large and small cap, value and growth, advisors have embraced ETFs as a way Investors need to monitor each ETF domestic and international, developed to gain exposure to myriad asset classes, to determine if it delivers. Ultra-short and emerging markets, traditional and including equities (large and small cap, ETFs, which seek to achieve double the alternative investments. With such an growth and value, domestic and opposite return of the benchmark in a array of investment strategies, investors international, developed and emerging), single day, were designed as a hedge for need to consider asset allocation, man- fi xed income (long and short duration, a falling market. Some were designed ager selection, and vehicle selection. Th ey AAA, or high-yield, Treasuries, or to provide two and three times the need to determine the correct percentage Treasury infl ation-protected securities downside protection. But in practice allocation to each asset class. Th ey need or TIPS), commodities (gold, silver, oil, many of these ETFs fail to mirror the to evaluate the various strategies, and water, and combinations), and alterna- downside, largely due to reset features. they need to determine whether to access tives (hedge funds, merger arbitrage, Many commodity ETFs don’t perform actively or passively. Deploying capital and global macro). as advertised, and they delivered K-1s intelligently is much more complex today ETF asset growth has been fueled rather than 1099s to boot. than it was with MPT. by the fact that active managers have ETNs snagged a lot of attention in diffi culty outperforming their passive 2008 due to counter-party risk.5 ETNs The Growth of ETFs benchmarks. ETF structure typically are an interesting structure, and in fact One signifi cant development has been is designed to off er cost-eff ective and certain strategies fi t better in an ETN the extraordinary growth of exchange- tax-effi cient exposure to the underly- than an ETF, making ETNs worthy of traded products such as ETFs and ing benchmarks. (Th ere also is growing investors’ consideration.

FIGURE 4: U.S. EXCHANGE-TRADED FUNDS AND PRODUCTS GROWTH

GLOBAL ETF AND ETP ASSET GROWTH 1,400 Assets US$ # products 3,000.0

1,200 2,500.0

1,000 2,000.0

800 1,500.0 600

1,000.0 400

500.0 200

0 0.0 Oct 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 ETF total $0.8 $1.1 $2.3 $5.3 $8.2 $17.6 $39.6 $74.3 $104.8 $141.6 $212.0 $309.8 $412.1 $565.6 $796.7 $711.1 $1,036.0 $1,239.0 ETF equity $0.8 $1.1 $2.3 $5.3 $8.2 $17.6 $39.6 $74.3 $104.7 $137.5 $205.9 $286.3 $389.6 $526.5 $729.9 $596.4 $841.6 $982.0 ETF fixed Income $0.1 $0.1 $4.0 $5.8 $23.1 $21.3 $35.8 $59.9 $104.0 $167.0 $215.2 ETF commodity $0.0 $0.1 $0.3 $0.5 $1.2 $3.4 $6.3 $10.0 $25.6 $37.5 ETP total $2.0 $5.1 $3.9 $4.1 $6.3 $9.3 $15.9 $32.5 $54.6 $61.2 $119.7 $153.6 # ETFs 3 3 4 21 21 31 33 92 202 280 282 336 461 714 1,172 1,595 1,945 2,409 # ETPs 2 14 17 17 18 22 64 170 371 612 724 995

Source: Global ETF Research & Implementation Strategy Team, BlackRock, December 2009

Core-Satellite FIGURE 5: TRADITIONAL FIGURE 6: ALTERNATIVE Perhaps the debate shouldn’t be “active CORE-SATELLITE MODEL CORE-SATELLITE versus passive,” but “active and passive.” Core-satellite investing off ers many variations of active-and-passive invest- Hedge Funds Commodities ment solutions. In the traditional con- Small REITs Inflation Real text, an investor would seek passive/beta Cap Hedging Growth Estate exposure to the most-effi cient markets Traditional Alternative and active/alpha solutions to the less- Beta Beta effi cient markets, as shown in fi gure 5. Small Cap Int'l Managed Private Figure 5 shows exposure to hedge Value Futures Equity funds as alpha, because in theory hedge Emerging Merger funds provide incremental return above Markets Arb. and beyond the passive benchmark. But the extraordinary growth of hedge funds is making it increasingly diffi cult classes such as hedge funds. Alternative Sharpe (1992) was the fi rst to bring the for hedge funds to deliver alpha. In beta is valuable, but it’s not worth the concept to the consulting community. fact, many hedge funds deliver beta— excessive fees typically charged by Academics recently suggested that alternative beta, but beta none the less. hedge funds. In other words, don’t pay hedge fund results can be replicated Alternative beta is the return derived alpha fees for beta results. through sophisticated regression analy- from having exposure to common sys- Academics have studied the separa- sis (Whitelaw et al. 2009). If alpha and tematic risk factors in alternative asset tion of alpha and beta for years, and beta can be separated, and hedge funds

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deliver alternative beta, then we have • How do you determine success or Endnotes a more-evolved core-satellite model, failure of your investment strategy? 1 Modern portfolio theory describes how risk- shown in fi gure 6. averse investors can construct portfolios to Figure 6 shows the alternative Investors also must consider how optimize or maximize expected return based core-satellite model with the alterna- best to gain exposure to a particular on a given level of market risk that is empha- tive exposures divided into sub-asset asset class. Investors need to evaluate sized as essential to achieve a higher reward. classes. Like traditional investments, individual managers and managers in 2 See, for example, Adam Shell, “Pimco’s some strategies are more prone than combination to build the optimal port- El-Erian: ‘New Normal’ Argues for others to deliver alpha relative to the folio. Investors also need to evaluate Investor Caution," USA Today (August 16, market. (Note that the hedge fund uni- which vehicle represents the best way 2010), available at http://www.usatoday. verse is the market for this example.) of accessing a manager. Th ey need to com/money/companies/management/ consider the value of a separately man- advice/2010-08-15-advice-el-erian_N.htm. Conclusion: aged account structure versus a mutual 3 Tail risk is a form of portfolio risk that Investment Implications fund structure. Th ey need to evaluate occurs when there is a high probability that Investors need to evolve their views on attributes of an ETF structure and the an investment will shift more than three asset allocation and manager selection. limitations of a limited partnership standard deviations from the mean. Rather than thinking about asset al- structure. 4 A manager’s past performance is not a location, manager selection, and vehicle MPT still off ers valuable lessons, but guarantee of future results. selection as separate decisions, investors investors need to evolve their views. 5 Counterparty risk is the risk to each party need to consider them all as part of an With the increasing rate of change and in a contract that the other won’t honor its integrated decision-making process. fl ow of information, investors need to contractual obligations. Th ey need to evaluate asset allocation be more responsive to change. You can (strategic and tactical) and manager se- call that the new normal or call it being References lection (active versus passive) as part of more tactical or adaptive. Brinson, Gary P., L. Randolph Hood, and the same investment process. MPT has Now more than ever, investors are Gilbert L. Beebower. 1986. Determinants of not become obsolete, but investors need seeking and may need professional help Portfolio Performance. Financial Analysts to be more responsive to the change and in developing long-term investment Journal 42, no. 4 (July/August): 39–44. complexity of the investment landscape. strategy. Th ey need guidance in respond- Malkiel, Burton. 1973. A Random Walk Down Investors have a number of factors ing to the rapidly changing investment Wall Street. (New York: W. W. Norton & to consider in developing investment landscape. Investors need to develop Company, Inc.). strategy. Th e following is a sample strategy that is adaptive and responsive Markowitz, Harry. 1952. Portfolio Selection. check list for investors and/or their yet disciplined enough to keep them on Journal of Finance 7, no. 1 (March): 77–91. advisors to consider: the right path. Investors need help and Sharpe, William F. 1964. Capital Asset Prices: • What is the appropriate long-term guidance from trained professionals who A Th eory of Market Equilibrium under strategic asset allocation? have evolved their own views on the new Conditions of Risk. Journal of Finance 19, • Should you allow for tactical investment paradigm. no. 3 (September): 425–442. changes? Sharpe, William. 1992. Asset Allocation: • Who is qualifi ed, and who should Anthony B. Davidow, CIMA®, is a Manage ment Style and Performance make tactical changes? managing director and portfolio Measurement. • How frequently should portfolios be strategist for Rydex/SGI. He serves Journal of Portfolio Management 18, no. 2 rebalanced or reallocated? on IMCA’s Board of Directors. (winter): 7–19. • Is the market effi cient? Is the market He earned a BBA in finance and Whitelaw, Robert, Salvatore J. Bruno, and always effi cient? investments from Bernard Baruch Anthony B. Davidow. 2009. Alpha/Beta • How should you evaluate invest- University. Contact him at Separation: Getting What You Pay For. ment options (individually and [email protected]. Investments & Wealth Monitor 24, no. 2 collectively)? (March/April): 38–42, 45. • Does active management perform Disclaimer: Opinions expressed are better than passive management? those of Mr. Davidow and not those To take the CE quiz online, visit www.IMCA.org. • Should you consider a core-satellite of Rydex/SGI or IMCA. Opinions approach? expressed are neither intended as invest- • Can you use core-satellite for alter- ment advice nor a recommendation or native investments? off er of any specifi c security or strategy.