From the Archives: Market Anxiety Disorder

September 24, 2013

A recent article in the Personal Finance section of the Wall Street Journal had a prescription for anxious investors that Andy has been talking about for more than a year: consider asset allocation funds.  Our Global Macro separate account has been very popular, partly because it allows investors to get into the market in a way that can be conservative when needed, but one that doesn’t lock investors into a product that can only be conservative.

The stock market’s powerful rally over the past year has gone a long way toward reducing the losses that many mutual-fund investors suffered in late 2007 and 2008.

But the rebound—with the Standard & Poor’s 500-stock index up 74% from its March 9, 2009, low—has done nothing for one group of investors: those who bailed out of stocks and have remained on the sidelines. Some of these investors have poured large sums into bond funds, even though those holdings may take a beating whenever interest rates rise from today’s unusually low levels, possibly later this year. Some forecasters, meanwhile, believe that stocks may finish 2010 up as much as 10%.

So, for investors who want to step back into stocks but are still anxious, here’s a modest suggestion: You don’t have to take your stock exposure straight up. You can dilute it by buying an allocation fund that spreads its assets across many market sectors, from stocks and bonds to money-market instruments and convertible securities.

While the WSJ article is a good general introduction to the idea, I think there are a few caveats that should be mentioned.

There’s still a big difference between a strategic asset allocation fund and a tactical asset allocation fund.

Many [asset allocation funds] keep their exposures within set ranges, while others may vary their mix widely.

Your fund selection will probably depend a lot on the individual client.  A strategic asset allocation fund will more often have a tight range or even a fixed or target allocation for stocks or bonds.  This can often target the volatility successfully–but can hurt returns if the asset classes themselves are out of favor.  Tactical funds will more often have broader ranges or be unconstrained in terms of allocations.  This additional flexibility can lead to higher returns, but it could be accompanied by higher volatility.

One thing the article does not mention at all, unfortunately, is that you also have a choice between a purely domestic asset allocation fund or a global asset allocation fund.  A typical domestic asset allocation fund will provide anxious investors with a way to ease into the market, but will ignore many of the opportunities in international markets or in alternative assets like real estate, currencies, and commodities.  With a variety of possible scenarios for the domestic economy, it might make sense to cast your net a little wider.  Still, the article’s main point is valid: an asset allocation fund, especially a global asset allocation fund, is often a good way to deal with a client’s Market Anxiety Disorder and get them back into the game.

—-this article originally appeared 4/7/2010.  Investors still don’t like this rally, even though we are a long way down the road from 2010!  An asset allocation fund might still be a possible solution.

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Stocks for the Long Run

September 20, 2013

Unlike certain authors, I am not promoting some agenda about where stocks will be at some future date!  Instead, I am just including a couple of excerpts from a paper by luminaries David Blanchett, Michael Finke, and Wade Pfau that suggests that stocks are the right investment for the long run—based on historical research.  Their findings are actually fairly broad and call market efficiency into question.

We find strong historical evidence to support the notion that a higher allocation to equities is optimal for investors with longer time horizons, and that the time diversification effect is relatively consistent across countries and that it persists for different levels of risk aversion.

When they examine optimal equity weightings in a portfolio by time horizon, the findings are rather striking.  Here’s a reproduction of one of their figures from the paper:

Source: SSRN/Blanchett, Finke, Pfau  (click to enlarge)

They describe the findings very simply:

Figure 1 also demonstrates how to interpret the results we include later in Tables 2 and 3. In Figure 1 we note an intercept (α) of 45.02% (which we will assume is 45% for simplicity purposes) and a slope (β) of .0299 (which for simplicity purposes we will assume is .03). Therefore the optimal historical allocation to equities for an investor with a 5 year holding period would be 60% stocks, which would be determined by: 45% + 5(3%) = 60%.

In other words, if your holding period is 15-20 years or longer, the optimal portfolio is 100% stocks!

Reality, of course, can be different from statistical probability, but their point is that it makes sense to own a greater percentage of stocks the longer your time horizon is.  The equity risk premium—the little extra boost in returns you tend to get from owning stocks—is both persistent and decently high, enough to make owning stocks a good long-term bet.

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From the Archives: Was It Really a Lost Decade?

February 28, 2013

Index Universe has a provocative article by Rob Arnott and John West of Research Affiliates.  Their contention is that 2000-2009 was not really a lost decade.  Perhaps if your only asset was U.S. equities it would seem that way, but they point out that other, more exotic assets actually had respectable returns.

The table below shows total returns for some of the asset classes they examined.

 Was It Really a Lost Decade?

click to enlarge

What are the commonalities of the best performing assets? 1) Lots of them are highly volatile like emerging markets equities and debt, 2) lots of them are international and thus were a play on the weaker dollar, 3) lots of them were alternative assets like commodities, TIPs, and REITs.

In other words, they were all asset classes that would tend to be marginalized in a traditional strategic asset allocation, where the typical pie would primarily consist of domestic stocks and bonds, with only small allocations to very volatile, international, or alternative assets.

In an interesting way, I think this makes a nice case for tactical asset allocation.  While it is true that most investors–just from a risk and volatility perspective–would be unwilling to have a large allocation to emerging markets for an entire decade, they might find that periodic significant exposure to emerging markets during strong trends would be quite acceptable.  And even assets near the bottom of the return table like U.S. Treasury bills would have been very welcome in a portfolio during parts of 2008, for example.  You can cover the waterfront and just own an equal-weighted piece of everything, but I don’t know if that is the most effective way to do things.

What’s really needed is a systematic method for determining which asset classes to own, and when.  Our Systematic Relative Strength process does this pretty effectively, even for asset classes that might be difficult or impossible to grade from a valuation perspective.  (How do you determine whether the Euro is cheaper than energy stocks, or whether emerging market debt is cheaper than silver or agricultural commodities?)  Once a systematic process is in place, the investor can be slightly more comfortable with perhaps a higher exposure to high volatility or alternative assets, knowing that in a tactical approach the exposures would be adjusted if trends change.

—-this article originally appeared 2/17/2010.  There is no telling what the weak or strong assets will be for the coming decade, but I think global tactical asset allocation still represents a reasonable way to deal with that uncertainty.

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Timeless Portfolio Lessons

February 1, 2013

The only thing new under the sun is the history you haven’t read yet.—-Mark Twain

Investors often have the conceit that they are living in a new era.  They often resort to new-fangled theories, without realizing that all of the old-fangled things are still around mainly because they’ve worked for a long time.  While circumstances often change, human nature doesn’t change much, or very quickly.  You can generally count on people to behave in similar ways every market cycle.  Most portfolio lessons are timeless.

As proof, I offer a compendium of quotations from an old New York Times article:

WHEN you check the performance of your fund portfolio after reading about the rally in stocks, you may feel as if there is  a great party going on and you weren’t invited. Perhaps a better way to look at it is that you were invited, but showed up at the wrong time or the wrong address.

It isn’t just you. Research, especially lately, shows that many investors don’t match market performance, often by a wide margin, because they are out of sync with downturns and rallies.

Christine Benz, director of personal finance at Morningstar, agrees. “It’s always hard to speak generally about what’s motivating investors,” she said, “but it’s emotions, basically,” resulting in “a pattern we see repeated over and over in market cycles.”

Those emotions are responsible not only for drawing investors in and out of the broad market at inopportune times, but also for poor allocations to its niches.

Where investors should be allocated, many professionals say, is in a broad range of assets. That will smooth overall returns and limit the likelihood of big  losses resulting from  an excessive concentration in a plunging market. It also limits the chances of panicking and selling at the bottom.

In investing, as in party-going, it’s often safer to  let someone else drive.

This is not ground-breaking stuff.  In fact, investors are probably bored to hear this sort of advice over and over—but it gets repeated because investors ignore the advice repeatedly!  This same article could be written today, or written 20 years from now.

You can increase your odds of becoming a successful investor by constructing a reasonable portfolio that is diversified by volatility, by asset class, and by complementary strategy.  Relative strength strategies, for example, complement value and low-volatility equity strategies very nicely because the excess returns tend to be uncorrelated.  Adding alternative asset classes like commodities or stodgy asset classes like bonds can often benefit a portfolio because they respond to different return drivers than stocks.

As always, the bottom line is not to get carried away with your emotions.  Although this is certainly easier said than done, a diversified portfolio and a competent advisor can help a lot.

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Quote of the Week

November 14, 2012

Nervous energy is a great destroyer of wealth.—-Fayez Sarofim

This quote was embedded in an article written by Jim Goff, the research director at Janus.  Along with making the case for equities, he talks about how important it is to have a reasonable allocation that you can stick with—and then to leave it alone.

Mr. Goff talks about the way in which many investors undermine their returns:

The average investor is far from contrarian. I remember  vividly when a strategist from a top-tier investment firm in the mid-1990’s  told me that while the S&P 500 had grown at 13% per year over the prior 10  years, the realized equity returns of his firm’s retail client base, on  average, had compounded at only 5% per year. The S&P would have turned  $100,000 into $339,000 during that period, but their average investor ended  with $163,000.

Often this is caused by jumping in and out of an asset class, rather than by making tactical adjustments within the asset class.  There’s nothing wrong with tactical asset allocation as long as it’s done systematically.  Even a lousy version of strategic asset allocation—carried out effectively—will probably beat what most investors are doing!  Either way, undisciplined fiddling often ruins investment results.  Mr. Sarofim’s quote is something to take to heart.

There are a couple of points relevant to portfolio management.

  1. Think about a reasonable asset allocation for your situation, one you can stick with.
  2. Have a systematic process for making portfolio adjustments, not one that is undisciplined and responsive to the news environment.

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Target-Date Fund-mageddon

September 26, 2012

Markets are rarely tractable, which is one reason why significant flexibility is required over an investment lifespan.  Flexibility is something that target-date funds don’t have much of.  In fact, target-date funds have a glidepath toward a fixed allocation at a specified time.  I’ve written about the problems with target-date funds extensively—and why I think balanced funds are a much better QDIA (Qualified Default Investment Alternative).  It appears that my concerns were justified, now that Rob Arnott at Research Affiliates has put some numbers to it.  According to an article in Smart Money on target-date funds:

A target-date fund is a one-decision mutual fund that you can invest in over the course of your entire career.

Each fund is designed for those aiming to retire at a certain date. The fund starts with a lot of “risky” stocks, and over time it moves to “safer” bonds. The fundamental idea is that at any given moment between age 21 and age 65 you should be invested in a particular balance of assets — more stocks when you are younger, and more bonds when you are older.

The track to retirement, according to the industry jargon, is a “glidepath.”

Billions of dollars are invested in these target-date funds. They are today the default investment option in many 401(k) plans. Now comes Rob Arnott, the chairman of Research Affiliates and one of the handful of serious money managers in the country. In a new research paper he published yesterday, “The Glidepath Illusion,” he has blown this idea full of holes. “Shockingly,” he says, “the basic premise upon which these billions [of dollars] are invested is flawed.”

When Mr. Arnott investigated the results of such target-date funds, he found them to be incredibly variable—and possibly upside-down.  (I put the fun part in bold.)

Arnott has mined data from the stock and bond markets going back to 1871 and then run simulations to see how these target-date portfolios would have worked in practice. He considered a fund that started out with 80% stocks and 20% bonds, and then adjusted gradually over an investing life of 41 years so that it ended up 80% bonds and 20% stocks. He considered an investor who invested $1,000 a year, adjusted for inflation, from the day she started work at age 22 to when she retired at 63.

Bottom line? This investor could have done very well — or very badly. Far from enjoying a smooth “glidepath” to a secure retirement, she could have retired with as little as $50,000 in savings or as much as $211,000. She could have ended up with a retirement annuity of $2,400 a year — or $13,100 a year. There was no way of knowing in advance.

That wasn’t all. Arnott found that in most eras, investors would have actually been better off if they had stood this target-date strategy on its head — in other words, if they had started out with 80% bonds, and then took on more risk as they got older, so that they ended up with 80% stocks.

No kidding. Really.

The median person following the target date strategy ended up with $120,000 in savings. The median person who did the opposite, Arnott’s team found, ended up with $148,000. The minimum outcome from doing the opposite was better. The maximum outcome of doing the opposite was also better.

Amazing.  Even the minimum outcome from going opposite the glidepath was better!  Using even a static 50/50 balanced fund was also better.  Perhaps this will dissuade a client or two from piling into bonds only because they are older.  No doubt path dependence had something to do with the way returns laid out, but it’s clear that age-based asset allocation is a cropper.

Asset allocation, diversification, and strategy selection are important.  Decision of this magnitude need to be made consciously, not put on autopilot.

[You can read Mr. Arnott’s full article here.  Given that most 401k investors are unfortunately using target-date funds instead of balanced funds, this is a must read.  I would modestly suggest the Arrow DWA Balanced Fund as a possible alternative!]

Click here to visit for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

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Are 401k Investors Making a Mistake with Hybrid Funds?

September 26, 2012

I think this is an open question after reading some commentary by Bob Carey, the investment strategist for First Trust.  He wrote, in his 9/11/2012 observations:

  • Hybrid funds, which tend to be comprised primarily of domestic and foreign stocks and bonds, but can extend into such areas as commodities and REITs, saw their share of the pie rise from 15% in Q1’07 to 22% in Q1’12.
  • One of the more popular hybrid funds for investors in recent years has been target-date funds. These funds adjust their asset mix to achieve a specific objective by a set date, such as the start of one’s retirement.
  • In 2010, target-date fund assets accounted for 12.5% of all holdings in employer-sponsored defined-contribution retirement accounts. They are expected to account for 48% by 2020, according to Kiplinger.
  • Plans are shifting away from the more traditional balanced funds to target-date funds for their qualified default investment alternative (QDIA).

There’s a nice graphic to go along with it to illustrate his point about the growing market share of hybrid funds.

Are 401k Investors Making a Mistake?

Source: First Trust, Investment Company Institute  (click to enlarge)

He points out that 401k assets in hybrid funds are rising, but the growth area within the hybrid fund category has been target-date funds.  It troubles me that many 401k plans are moving their QDIA option from balanced funds to target-date funds.  QDIAs are designed to be capable of being an investor’s entire investment program, so the differences between them are significant.

There is a huge advantage that I think balanced funds have–much greater adaptability to a broader range of economic environments.  Balanced funds, particularly those with some exposure to alternative assets, are pretty adaptable.  The manager can move more toward fixed income in a deflationary environment and more toward equities (or alternative assets) in a strong economy or during a period of inflation.

Most target-date funds have a glide path that involves a heavier and heavier allocation to bonds as the investor ages.  While this might be worthwhile in terms of reducing volatility, it could be ruinous in terms of inflation protection.  Inflation is one of the worst possible environments for someone on a fixed income (i.e. someone living off the income from their retirement account).  Owning bonds just because you are older and not because it is the right thing to do given the market environment seems like quite a leap of faith to me.

Asset allocation decisions, whether strategic or tactical, should be investment decisions.

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Wealth Drivers in 401k Accounts

September 10, 2012

Putnam Investments recently completed a study in which they examined the wealth drivers in 401k plans for individuals.  (I first saw the discussion of their study in this article at AdvisorOne.  The full Putnam study is here.)  What they did was very clever: they built a base case, and then made various modifications to see what changes had the most impact in driving wealth.  Here was their base case:

They assumed that a 28-year-old in 1982 earned $25,000 per year with a 3% cost-of-living increase. The worker contributes 3% of gross salary to a 401(k) plan that receives a 50-cent match on the dollar up to 6% and has a conservative asset allocation across six asset classes. The hypothetical 401(k) also invests in funds in the bottom 25% of their Lipper peer group. By the time the worker turns 57 in 2011, income is $57,198, and the 401(k) balance is $136,400.

Then Putnam examined three sets of wealth drivers to see how they impacted the base case:

  1. They changed the 4th quartile mutual funds to 1st quartile funds, but kicked out funds after three years if they fell out of the 1st quartile.
  2. They looked at the effect of adding more equities to the mix, so they boosted stocks from 30% of the account to 60% and to 85%.
  3. They looked at quarterly rebalancing of the account.

The results were pretty interesting.  Picking “better” funds, in concert with the replacement strategy, was actually $10,000 worse than the base case!  The portfolios with more equities had their balances boosted by $14,000 and $23,000 respectively—but, of course, they were also more volatile.  Rebalancing added $2,000 to the base portfolio balance, but slightly reduced the volatility as well.

All of these strategies—fund selection, asset allocation, and rebalancing—are commonly offered as value propositions to 401k investors, yet none of them really moved the needle much.  (Even a “crystal ball” strategy that predicted which funds would become 1st quartile funds only helped balances by about $30,000.)

Then Putnam explored three variations of a mystery strategy.  The first version improved the final balance by $45,000; the second version boosted the balance by an additional $136,000; and the third version blew away everything else by adding another $198,000 to the $136,000 base case, for a final balance of $334,000!

What was this amazing mystery strategy?  Saving more!

The three variations simply involved moving the 401k deferral rate up from 3% to 4%, 6%, and 8%.  That’s it.

The mathematics of compounding over time are very powerful.  Because this study looked at the 1982-2011 time period, higher contributions had time to compound.  Even moving up the contribution rate by 1% dominated all of the investment gyrations.

The power of compounded savings is often overlooked, almost always by clients and even frequently by advisors.  Often one of the best things you can do for your clients is just to get them to boost their deferral rate by a percent or two.  They might squawk, but in six months they will usually not even notice it.  Then it’s time to get them to boost their deferral rate again!  Over time, people are often shocked at how much they can save without really noticing.

Clients often obsess over their fund selection and investment strategy, when they really should be paying attention to their savings rate.

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Uncertainty and its Investment Implications

September 6, 2012

Uncertainty is usually problematic for investors.  If the economy is clearly good or decidedly bad, it’s often easier to figure out what to do.  I’d argue that investors typically overreact anyway, but they at least feel like they are justified in swinging for the fence or crawling into a bomb shelter.  But when there is a lot of uncertainty and things are on the cusp—and could go either way—it’s tough to figure out what to do.

The chart below, from the wonderful Calculated Risk blog, demonstrates the point perfectly.

Source: Calculated Risk  (click to enlarge)

You can see the problem.  The Purchasing Managers’ Index is hovering right near the line that separates an expanding economy from a contracting one.  There’s no slam dunk either way—there are numerous cases of the PMI dropping below 50 that didn’t result in a recession, but also a number that did have a nasty outcome.

So what’s an investor to do?

One possibility is an all-weather fund that has the ability to adapt to a wide variety of environments.  The old-school version of this is the traditional 60/40 balanced fund.  The idea was that the stocks would behave well when the economy was good and that the bonds would provide an offset when the economy was bad.  There are a lot of 60/40 funds still around, largely because they’ve actually done a pretty reasonable job for investors.

The new-school version is the global tactical asset allocation fund.  The flexibility inherent in a tactical fund allows it to tilt toward stocks when the market is doing well, or to tilt toward bonds if equities are having a rough go.  Many funds also have the potential to invest across alternative asset classes like real estate, commodities, or foreign currencies.

For a client that is wary of the stock market—and that might include most clients these days—a balanced fund or a global tactical asset allocation fund might be just the way to get them to dip their toe in the water.  They are going to need exposure to growth assets over the long run anyway and a flexible fund might make that necessary exposure more palatable.

Click here to visit for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

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The Disciplined Pursuit of Less

August 23, 2012

Greg McKeown’s “The Disciplined Pursuit of Less” in the Harvard Business Review is thought-provoking on so many levels.  The article must be read in full  to really appreciate his point, but the concluding paragraph is a nice summary.

If success is a catalyst for failure because it leads to the “undisciplined pursuit of more,” then one simple antidote is the disciplined pursuit of less. Not just haphazardly saying no, but purposefully, deliberately, and strategically eliminating the nonessentials. Not just once a year as part of a planning meeting, but constantly reducing, focusing and simplifying. Not just getting rid of the obvious time wasters, but being willing to cut out really terrific opportunities as well. Few appear to have the courage to live this principle, which may be why it differentiates successful people and organizations from the very successful ones.

While this principle can be applied to nearly every aspect of our lives, it has a clear application to portfolio construction and financial planning.  Some variation of the following story is common: An individual succeeds at earning a high income.  Either on his own or with the help of a financial advisor, investments are made.  The years pass.  Additional investments are made.  Money with a money manager here, a group of mutual funds there, positions in some individual stocks here…  Pretty soon, this person has become a collector as opposed to an investor.  In the collector scenario, it is just possible that everything works out okay.  Perhaps there will be big enough winners in the mix to cover any losers.  However, it is possible that some of those investments were ill-conceived and will be a major drag on the overall portfolio over time–all while not being carefully watched.

Contrast that approach with the investor who purposely employs an asset allocation with more limited, but thoroughly researched investment strategies (we have written many times before about the rationale for mixing relative strength, value, and low volatility strategies).  It is quite possible that this more disciplined investor will be able to earn greater returns and amass greater wealth over time than the collector and still retain the benefits of diversification.

No realistic person has the expectation of a perpetual state of success.  Setbacks are just part of life and investing.  However, the investor who purposefully, deliberately, and strategically eliminates the nonessentials and focuses their resources on the areas where they are likely to achieve the greatest rewards has taken a big step towards putting the odds in their favor.

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The Purpose of Fixed Income

June 27, 2012

Bill Bernstein is an asset allocation expert and the author of The Four Pillars of Investing.  He happened to be at the current Morningstar Investment Conference and had an interview with Christine Benz, one of my favorite writers at Morningstar.  She asked him about the purpose of fixed income in portfolios.  I thought his answer was very revealing.  It might not be controversial among financial advisors, but I doubt it is the thought process behind the retail public, which is currently pouring money into bond funds.  (I’ve bolded the fun parts.  You can read the whole transcript of the interview here.)  I don’t agree with Mr. Bernstein’s view on a lot of things, but this seems pretty sensible to me.

Benz: Bill, I would like to focus on fixed income today. You are an expert on asset allocation, and I think that everywhere you go right now, you hear gloomy prognostications about the outlook for fixed income. I’m wondering if you can talk about how investors should approach that allocation right now given the prospective headwinds that could face fixed-income investors in the decades ahead?

Bernstein: Well, first of all, there’s a lot of concern about fixed income as you’ve already alluded to. People are worried that the returns are going to be low, and I think that’s almost a mathematical certainty. If yields stay where they are you’re going to get a very low yield; that’s the best-case scenario. If yields rise from here, then you are going to achieve probably negative returns with any duration at all. Yields on Treasuries have fallen over the past 30 years from the midteens down to 0%, 1%, or 2%; they can’t fall another 14% from here. And I think unfortunately people are expecting that to happen. So you have to back up and ask yourself, what is the purpose of your fixed-income assets? Well, they’re for emergency needs. They’re to buy stocks when they are cheap, so you can sleep at night. And they’re to buy that corner lot from your impecunious neighbor who suddenly has a need of cash. It’s not to achieve a return.

In short, bonds are part of your portfolio as a placeholder.  You buy bonds when you don’t want the money to evaporate because you will need it later for an emergency, or because you will use it to buy other productive assets at a favorable price.  Mr. Bernstein doesn’t think you should buy bonds here and expect a return.  Sure, they might cushion a portfolio’s overall volatility, but his main point is that bonds right now should be held tactically in favor of deploying into other assets when the time is right.

I’d say this is pretty close to our view on fixed income.  It’s a risk-off asset class, but it doesn’t make sense to have a large allocation when risk assets are performing well.  Individuals might want bonds to reduce their portfolio volatility to levels they deem acceptable, but the focus should always be on assets that can grow.

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From the Archives: Is Buy-and-Hold Dead?

June 20, 2012

The  Journal of Indexes has the entire current issue devoted to articles on this topic, along with the best magazine cover ever.  (Since it is, after all, the Journal of Indexes, you can probably guess how they came out on the active versus passive debate!)

One article by Craig Israelson, a finance professor at Brigham Young University, stood out.  He discussed what he called “actively passive” portfolios, where a number of passive indexes are managed in an active way.  (Both of the mutual funds that we sub-advise and our Global Macro separate account are essentially done this way, as we are using ETFs as the investment vehicles.)  With a mix of seven asset classes, he looks at a variety of scenarios for being actively passive: perfectly good timing, perfectly poor timing, average timing, random timing, momentum, mean reversion, buying laggards, and annual rebalancing with various portfolio blends.  I’ve clipped one of the tables from the paper below so that you can see the various outcomes:

 Is Buy and Hold Dead?

Click to enlarge

Although there is only a slight mention of it in the article, the momentum portfolio (you would know it as relative strength) swamps everything but perfect market timing, with a terminal value more than 3X the next best strategy.  Obviously, when it is well-executed, a relative strength strategy can add a lot of return.  (The rebalancing also seemed to help a little bit over time and reduced the volatility.)

Maybe for Joe Retail Investor, who can’t control his emotions and/or his impulsive trading, asset allocation and rebalancing is the way to go, but if you have any kind of reasonable systematic process and you are after returns, the data show pretty clearly that relative strength should be the preferred strategy.

—-this article originally appeared 1/8/2010.  Relative strength rocks.

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7 Questions to Consider When Doing Asset Allocation

March 13, 2012

Here are seven questions that can lay the foundation for a fruitful relationship between a financial advisor and their client:

Question #1:  What investments make up your investment universe?  Does your investment strategy allow you to invest in a broad range of asset classes, including U.S. equities, international equities, currencies, commodities, real estate, and fixed income?

Question #2:  What role do current market conditions play in the asset allocation decision-making process?  Does your investment strategy have a means of increasing exposure to asset classes in secular bull markets and decreasing exposure to asset classes in secular bear markets?

Question #3:  Does your portfolio include investments in complementary strategies?  Relative strength and value are both long-term winning investment factors.  They also tend to have low, or even negative correlations to each other, thereby providing useful diversification.

Question #4:  Is your asset allocation divided into segments?  Breaking a portfolio into an income segment, balanced segment, and growth segment can provide tremendous psychological benefits and therefore may increase the odds that you will stick with your investment plan over time.

Question #5:   Do you have a plan for systematic contributions?  There are many ways to accomplish this goal, including setting up a monthly automatic withdrawals from your bank to your brokerage account or regularly sending 15% of every dollar earned to your brokerage account, but the key is to have some systematic means of continuing to save money for your financial goals.

Question #6:  Do you have a plan for how you will approach distributions from your portfolio during retirement?

Question #7:  Do you have a financial advisor that will give you the TLC you will need to be educated and guided along all the inevitable bumps in the road?

Some relevant resources:

Savings or Growth? 

Expected Returns

Safe Withdrawal Rates

What’s Your Retirement Number?

Strategic Allocation Bites

The Upside of Mental Accounting

The Bucket List

Combining Global Macro & MDLOX

Why Tactical Asset Allocation

What is a Balanced Fund, and Why Should You Care?

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Relative Strength–A Critical Portfolio Management Tool

February 13, 2012

Mike Moody’s Relative Strength–A Critical Portfolio Management Tool now appears in the current issue of IMCA’s Journal of Investment Consulting.  Whether you are managing relative strength portfolios yourself or you are employing relative strength strategies, this article answers the essential questions:

  • What is relative strength?
  • Why does it work?
  • Where does it work?
  • What have been the results?
  • What are its drawbacks?
  • How does it fit in an asset allocation?

Click here to read the article.


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Ibbotson Kills Strategic Asset Allocation

March 11, 2010

Today we celebrate the death of another myth–that asset allocation is responsible for 90% of your return–surprisingly done in by none other than Roger Ibbotson of Ibbotson Associaties, purveyors of the ubiquitous asset class return charts.  This myth is particularly pernicious because it is used by strategic asset allocators of all stripes to imply that active management or stock picking doesn’t really matter–if you just allocate properly you will be fine.

There are two problems with the myth that asset allocation is responsible for 90% of your returns:  1) the original Brinson et al. (BHB) study actually said that asset allocation explained 90% of the variation in returns between two sets of institutional portfolios, and 2) even that was wrong.  In his recent article in the Financial Analysts Journal, “The Importance of Asset Allocation.” Roger Ibbotson writes:

Surprisingly, many investors mistakenly believe that the BHB (1986) result (that asset allocation policy explains more than 90 percent of performance) applies to the return (the 100 percent answer).  BHB, however, wrote only about the returns, so they likely never encouraged this misrepresentation.

Whether BHB ever encouraged it or not, the misreading of the results was seized upon by hungry marketing departments everywhere to serve their own purposes.   

Calculating the actual impact of active management versus the impact of asset allocation is actually pretty tricky.  There have been several different studies that address it and their numbers vary, depending on the time horizon and the type of portfolio.  Ibbotson’s own research into this area concludes:

Ibbotson and Kaplan (2000) presented a cross-sectional regression on annualized cumulative returns across a large universe of balanced funds over a 10-year period and found that about 40 percent of the variation of returns across funds was explained by policy.

Clearly, 40% is a whole lot different than 90%.  It turns out that active management and stock selection is way, way more important than the strategic asset allocation crowd would like to admit. 

Tactical asset allocation and active management may have a major role if investor returns are significantly dependent not just on how you are allocated, but on exactly what you own and when.  Ibbotson’s article points out that:

The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent of the variation in returns is caused by the specific asset allocation mix. Instead, most time-series variation comes from general market movement, and Xiong, Ibbotson, Idzorek, and Chen (forthcoming 2010) showed that active management has about the same impact on performance as a fund’s specific asset allocation policy.

The emphasis is mine, but the “replacing folklore with reality” phrasing is pretty strong for an academic journal.  Modern portfolio theory and its near cousin, strategic asset allocation, however, seem to be dying a lingering death.  It is still the dominant method of structuring portfolios, but clearly it is just as important to consider tactical asset allocation and to make sure that active management processes are robust.  The next time you read the 90% number somewhere, I hope you will give it the consideration it deserves—none.

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