Are we failing clients in asset allocation?

Most financial planners see asset allocation as one of their primary responsibilities. If you accept the conventional wisdom, asset allocation determines around 90 per cent of returns. But what are planners doing in this important area? Not much, it would seem. In most cases, the asset allocations solutions being offered today are unimaginative, backward looking and simplistic.

In this article I will look at what I believe are the limitations of the approach to asset allocation used by most planners. In my next article I will put forward the basis for a different approach that attempts to overcome these limitations.

In general terms, the approach to asset allocation used by most in the financial planning (and fund management) industry can be described as:

nDeveloping five or six static benchmark (strategic) asset allocations that match a particular client risk profile. These asset allocations may be reviewed and slightly changed every fewyears but essentially could be considered set-and-forget portfolios. Little if any tactical asset allocation around these benchmarks is undertaken;

nUsing conventional asset classes only with increasing proportions in Australian and overseas shares, and decreasing exposure to defensive cash and fixed interest as the risk profile increases. There is usually very limited ability for the underlying specialist fund managers to undertake any asset allocation, such as hold cash;

nSupporting these benchmarks with a quantitative analysis of how the particular benchmark asset mix would have performed over the previous 15 to 20 years (range of returns, volatility, chance of a negative year and so on);

nEach of the asset allocation benchmarks typically has medium to long-term absolute return objectives (CPI plus a margin), with this margin rising as the equity component increases; and

nOngoing asset allocation under this approach simply involves re-balancing back to these strategic allocations periodically as markets move or if changed circumstances shift the client into another risk profile.

There are a number of problems with these arrangements.

Firstly, they are highly dependent on the view that shares will outperform other assets over the long (and even medium) term.While generally true, this is occasionally not the case, and is less likely looking forward from periods where equities have been valued higher, and performed better, than long-term averages.

Secondly, they assume the behaviour of financial markets over periods of recent history (typically around 20 years) is a reliable estimate going forward.

Not only are past returns an unreliable estimate of future returns, they are often a perverse indicator. Historical returns are usually the highest at market peaks and the lowest at market bottoms. In any case, determining asset allocation should primarily be a forward, not backward-looking exercise.

Thirdly, they assume that some degree of active asset allocation to increase returns and/or to decrease risk is unnecessary or impossible to do successfully. It is not surprising that when hardly anyone is seriously attempting a more active asset allocation approach, you will struggle to find much evidence of success. However, its success should be judged over the medium and long-term, not just the short-term.

Furthermore, asset allocation is as much about managing risk as adding return (and I’m not talking about volatility here). There are periods of history such as most of the 1990s where it was difficult to add value in asset allocation simply because most assets were doing well and real risk was forgotten. However, usually this precedes periods where asset allocation is most needed and is most capable of adding value.

Fourthly, they assume that alternative assets — such as hedge funds, commodities and private equity — have little or no role in clients’ asset allocation. There has been much discussion about alternative assets in recent years. However, they still represent next to zero weighting in most planners (and fund managers) formal asset allocation models. Perhaps they are seen as too difficult to explain to clients or the master trusts that planners use do not accommodate them because they are less liquid.

But it is the planners who are not using alternatives who should be required to explain why and if master trusts cannot come up with a solution to include these structures they risk becoming seen as an obsolete investment platform.

Finally, the asset allocation benchmarks have a long-term absolute return focus and yet the managers/funds selected for achieving (or bettering) each asset class’ returns almost always have a relative return focus. There is therefore a major disconnect between the portfolio’s make up on a relative return basis and their ultimate medium to long-term absolute return objective.

Will not good relative returns lead to good absolute returns? Not always, as the past three to five years in some asset classes show. If you are targeting an absolute return objective, you need an absolute return approach to portfolio asset allocation and portfolio construction.

What is a ‘strategic’ or benchmark asset allocation anyway? Some suggest it is the asset allocation mix that will deliver a particular level of risk and return outcome looking forward. If markets were totally efficient this might be acceptable. In the real world where assets can become over or undervalued (and bubbles and busts do occur), no fixed asset allocation will deliver a stable risk or return profile over time.

In fact, there is no predetermined risk premium (excess return) from equities or bonds over 10 to 15 year time periods. This varies markedly over time. To maintain a constant level of risk you actually need to review and periodically change your asset allocation as market valuations and long-term asset prospects change.

Others suggest it is the neutral asset allocation, ie. the asset allocation you hold when you don’t have a strong ‘tactical’ view on an asset class. Neutral to what? This still tells you nothing about how you arrived at the strategic asset allocation in the first place.

In any case, the debate over strategic asset allocations and tactical asset allocations around them is missing the point. The important asset allocation for a client is the one they have today. If the market rises or falls 20 per cent, it is your actual asset allocation that will move by this amount. Whether this allocation is tactical or strategic is irrelevant.

Still, most adopt a ‘strategic’ view and set about allocating an amount to all the conventional assets available. I am all for diversification, but only into assets that make sense from an investment perspective, not just from an historical return perspective.

Of course, it is not only financial planners that are in the asset allocation business. Fund managers don’t have much to crow about either.

Most diversified balanced funds have adopted near passive asset allocations with small ranges that are heavily driven by their competitors’ mix. The few that implement active asset allocation typically do it through poorly functioning investment committees that focus on the next months or quarter, a time frame over which it is extremely difficult to add value. The evidence that such managers have not added value then gives them and the industry an excuse to devote even less resources and effort to the asset allocation issue. Business risk management, not investor risk management, becomes the overwhelming priority.

Solving the asset allocation problem for investors is not easy. But in response to these difficulties, the industry seems to have thrown in the towel. It has largely abandoned any form of active asset allocation at a time when it is most needed.

Investment returns are likely to get worse before they get better and clients will increasingly ask what they are receiving for their fees. No-one can expect to avoid negative returns at times but showing three to five-year returns below cash for conventional diversified portfolios is hardly indicative of an industry delivering on client expectations.

Given current valuations and an ongoing bear market environment, equity market returns could well be subdued for some time and investors will learn that equity markets can return less than other assets for extended periods.

The passive asset allocation approach that relies almost entirely on equity market outperformance to meet client objectives will be seen for what it is, overly simplistic, naive and unsuited to the times. Alternative approaches are clearly needed.