by Harold Evensky, CFP®, AIF® (editor); John Clark, Ph.D., CFA, CFP®; and Brian Boscaljon, Ph.D., CFA
Harold Evensky, CFP®, AIF®, is chairman of Evensky & Katz in Coral Gables, Florida. He is an internationally recognized speaker on investment and financial planning issues and is the author of Wealth Management and co-editor of The Investment Think Tank, Theory, Strategy, and Practice for Advisers.
John Clark, Ph.D., CFA, CFP®, is associate professor of finance at the Henry W. Bloch School of Business and Public Administration, University of Missouri-Kansas City.
Brian Boscaljon, Ph.D., CFA, is executive VP of the Academy of Financial Services and an associate professor in finance at the Sam and Irene Black School of Business, Penn State Erie.
In my last article I announced big news, namely that I had teamed with the members of the Academy of Financial Services (an organization of academics and practitioners with the mission to encourage basic and applied research in the area of personal financial planning and financial services and encourage interaction between financial services professionals and academicians) to expand the intellectual resources devoted to this column. I have to admit that I had some trepidation. In the past, as sole author of this column, I had complete control over its content. I was worried that under my new grand design I would be totally dependent on what my new co-authors provided. Silly me! My first contributors, professors John Clark and Brian Boscaljon, have prepared a thoughtful and practical review of current research related to issues of asset allocation. The focus of their contribution could not be more timely for practitioners; namely, asset allocation in today’s environment.
I know you will not only enjoy but benefit from the following contribution by professors Clark and Boscaljon.
Is a New Era of Asset Allocation Replacing Well Known Rules of Thumb?
Asset allocation has received a great deal of attention over the past two decades. The focus of this article will be on recent innovations regarding the asset allocation process. A great place to start is with Moshe Milevsky’s book published last year, Are You a Stock or a Bond? Create Your Own Pension Plan for a Secure Financial Future, 2009, FT Press. The need for financial planning for individuals has never been greater as the trend away from defined benefit plans toward defined contribution plans continues.
Milevsky provides practical new insights for the individual in the asset allocation decision process on both ends of the life-cycle spectrum that is relatively easy to understand and implement. As the title suggests, Milevsky provides numerous examples that illustrate the uniqueness of individuals, comparing them to either a stock or a bond. Individuals are advised to consider how their future salaries (referred to as human capital by economists) may be affected by market events. Thus, if individuals have salaries that are highly correlated with the market, such as a stockbroker, they are advised to take a less risky asset allocation. Whereas, tenured university professors are in a position to take on more risk in their financial investments because their human capital is more like a bond. Good advice for the young individual.
The last three chapters of the book emphasize the importance of product allocation rather than asset allocation. He provides a detailed model for determining the probability of retirement ruin and prescribes appropriate mixtures of three groups of assets for retirement: systematic withdrawal plan (or SWiP), variable annuities, and lifetime pay-out income annuities (LPIAs). Retired individuals are no longer concerned with whether or not they are a stock or bond and how much the market moves. Rather, the new product allocation is designed to combat longevity, inflation, and sequence of returns risk.
“What Should Your Asset Allocation Be When You Retire?” Journal of Wealth Management, Spring 2010. In this study, John Okunev tests tactical asset allocation (TAA) techniques against a well known rule of thumb presented by Bengen (1994) and Cooley, Hubbard, and Walz (1998), who suggest retirement portfolios can sustain inflation-adjusted withdrawal rates over a 30-year time horizon with an equity allocation of 50 to 75 percent. They examine three TAA approaches: modeling time varying equity risk premium (Arnott and Sorenson, 1988), constant proportion portfolio insurance (Perold and Sharp, 1988), and value at risk approach (Lewis, Okunev, and White, 2007). Okunev concludes from 10 years of historical annual data that the TAA approaches perform substantially better in down markets, but may not generate as high of returns in bull markets. This is not surprising given that the strategies are designed to protect against down-side risk. Thus, TAA strategies may bring more peace of mind in markets with greater uncertainties.
Another recent article that focuses on asset allocation during retirement is “Allocation to Deferred Variable Annuities with GMWB for Life,” Journal of Financial Planning, February 2010. James Xiong, Thomas Idzorek, and Peng Chen from Ibbotson Associates summarize their study by suggesting the following guidelines related to asset allocations for deferred variable annuities with guaranteed minimum withdrawal benefits for life (VA+GMWB). All other things equal, they suggest as expected the higher the life expectancy the higher the allocation to VA+GMWB. Conversely, individuals with higher age, risk tolerance, or ratios between wealth and income gap should allocate lower amounts to VA+GMWB.
This same group of Ibbotson Associates collaborates with Roger Ibbotson to write “The Equal Importance of Asset Allocation and Active Management,” Financial Analysts Journal, March/April 2010, which revisits the issue first raised by Brinson, Hood, and Beebower in their now widely cited 1986 article entitled “Determinants of Portfolio Performance.” They begin by decomposing a portfolio’s total return into three parts: (1) market return, (2) asset allocation policy return in excess of market return, and (3) return from active portfolio management. Then, using time-series and cross-sectional analysis, they suggest the market return is the most important determinant of total return. They go on to examine the results for specific peer groups after removing the market return component of total return and find, as suggested by the title of the article, that asset allocation policy returns in excess of market return and active portfolio management are equally important.
In a separate article entitled “The Importance of Asset Allocation” in the same journal issue, Roger Ibbotson confirms that asset allocation is important, but nowhere near the 90 percent folklore. The methodology of BHB and subsequent studies incorrectly tied 100 percent of the return variation to asset allocation when, in reality, the variation was the result of stock selection and general market movement. Emphasizing the equality of importance of these two determinants is good advice, but something tells us we haven’t heard the last of this continuing saga. An SSRN working paper entitled “Measuring the Performance of Life-Cycle Asset Allocation,” September 2010, by Thomas Post and Joan Schmit, challenges the classic 100-minus-age rule of thumb and prescribes alternative approaches for measuring the performance of individuals’ portfolios.
Adjusting Asset Allocation
The extremes of market behavior in the past few years have inspired a stream of research that focuses on adjusting traditional asset allocation models to more accurately reflect the realities of market volatility. Briére, Burgues, and Signori investigate the impact of including separate exposure to equity volatility through implied volatility and volatility risk premium strategies in “Volatility Exposure for Strategic Asset Allocation,” Journal of Portfolio Management, Spring 2010. By including these positions in portfolios they were able to improve both absolute and risk-adjusted returns and at least partially hedge the downside risk of a portfolio. In “Non-Normality of Market Returns: A Framework for Asset Allocation Decision Making,” Journal of Alternative Investments, Winter 2010, Abdullah Sheikh and Hongtao Qiao provide a methodology for making asset allocation decisions that adjusts for the lack of normality in observed asset return behavior. This methodology allows asset allocation to incorporate the impact of fat-tail events, correlation convergence, and serial correlation that often occur during extreme downward market movements, which can lead to more effective portfolios over time.
James Xiong and Thomas Idzorek of Ibbotson and Associates further explore the idea of incorporating non-normal return histories into the asset allocation decision in a white paper titled “Mean-Variance Versus Mean-Conditional Value at Risk Optimization: The Impact of Incorporating Fat-Tails and Skewness into the Asset Allocation Decision,” February 2010. They find that when skewness and kurtosis are incorporated into their optimization algorithm, substantially different asset allocations become optimal relative to traditional mean-variance optimization results. Based on a series of controlled optimizations, their results suggest that portfolios should typically increase exposure to non-U.S. debt, developed country equity, and non-U.S. REITs relative to the results from MVO.
Another interesting piece on asset allocation focuses on the notion that most long-term investors have multiple time horizons for various parts of their portfolio. In “Multi-Horizon Investing: A New Paradigm for Endowments and Other Long-Term Investors,” Journal of Wealth Management, Summer 2010, authors Robert Jaeger, Michael Rausch, and Margaret Foley suggest most investors have a series of short-term, intermediate-term, and long-term goals that should be funded in a series of sub-portfolios that can meet the particular obligation. For example, an individual might be saving to buy a car next year, funding college savings accounts for children, and funding a retirement portfolio at the same time. Each of these sub-portfolios has different liquidity requirements and time horizons, which will directly affect the expected returns and investment objectives applied to each. As a result, asset allocation decisions should be made at the sub-portfolio level rather than at the total portfolio level. Travis Jones and Jack Brown also consider this issue in “Integrating Asset-Liability Risk Management with Portfolio Optimization for Individual Investors,” Journal of Wealth Management, Winter 2009. They develop an approach that utilizes multi-horizon cash flow matching within a mean-variance optimization framework.
Market Efficiency
A new area of research is focusing on how to reconcile the concept of market efficiency with the existence of bubbles and crashes. In “Survival of the Richest,” Journal of Portfolio Management, Spring 2010, Andrew Lo attempts to reconcile this by explaining a new theory called the “adaptive markets hypothesis” (AMH). The article concludes that because of the increased volatility in the market, asset allocation policies as well as passive investing must become more dynamic and sensitive to risk.
William Sharpe develops a new model that has the potential to change the way many investors think about rebalancing. His goal in “Adaptive Asset Allocation Policies,” Financial Analysts Journal, May/June 2010, is to develop a rebalancing model that discourages the contrarian nature of traditional rebalancing techniques where one effectively divests winners to buy recent losers. The basis for this model is that rebalancing should be made in the context of relative shifts in the overall value of debt and equity in the market.
Clearly, the recent market volatility has inspired some interesting research on asset allocation policies that have major implications for financial planning practices and their clients. We hope you find these articles as insightful as we did.
References
Arnott, R., and E. Sorenson. 1988. “The Risk Premium and Stock Market Performance.” Journal of Portfolio Management (Summer): 50–55.
Bengen, W. 1994. “Determining Withdrawal Rates Using Historical Data.” Journal of Financial Planning (October): 14–24.
Briére, Marie, Alexandre Burgues, and Ombretta Signori. 2010. “Volatility Exposure for Strategic Asset Allocation.” Journal of Portfolio Management (Spring).
Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower. 1986. “Determinants of Portfolio Performance.” Financial Analysts Journal (July/August).
Cooley, P., C. Hubbard, and D. Walz. 1998. “Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable.” AAII Journal (February): 16–21.
Ibbotson, Roger. 2010. “The Importance of Asset Allocation.” Financial Analysts Journal (March/April).
Ibbotson, Roger, et al. 2010. “The Equal Importance of Asset Allocation and Active Management.” Financial Analysts Journal (March/April).
Jaeger, Robert, Michael Rausch, and Margaret Foley. 2010. “Multi-Horizon Investing: A New Paradigm for Endowments and Other Long-Term Investors.” Journal of Wealth Management (Summer).
Jones, Travis, and Jack Brown. 2009. “Integrating Asset-Liability Risk Management with Portfolio Optimization for Individual Investors.” Journal of Wealth Management (Winter).
Lewis, N., J. Okunev, and D. White. 2007. “Using a Value at Risk Approach to Enhance Tactical Asset Allocation.” Journal of Investing (Winter).
Lo, Andrew. 2010. “Survival of the Richest.” Journal of Portfolio Management (Spring).
Milevsky, Moshe. 2009. Are You a Stock or a Bond? Create Your Own Pension Plan for a Secure Financial Future. Upper Saddle River: FT Press.
Okunev, John. 2010. “What Should Your Asset Allocation Be When You Retire?” Journal of Wealth Management (Spring).
Perold, A., and W. Sharpe. 1988. “Dynamic Strategies for Asset Allocation.” Financial Analysts Journal: 16–27.
Post, Thomas, and Joan Schmit. 2010. “Measuring the Performance of Life-Cycle Asset Allocation.” SSRN Working Paper (September): http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1458898.
Sharpe, William. 2010. “Adaptive Asset Allocation Policies.” Financial Analysts Journal (May/June).
Sheikh, Abdullah, and Hongtao Qiao. 2010. “Non-Normality of Market Returns: A Framework for Asset Allocation Decision Making.” Journal of Alternative Investments (Winter).
Xiong, James, Thomas Idzorek, and Peng Chen. 2010. “Allocation to Deferred Variable Annuities with GMWB for Life.” Journal of Financial Planning (February).
Xiong, James, and Thomas Idzorek. 2010. “Mean-Variance Versus Mean-Conditional Value at Risk Optimization: The Impact of Incorporating Fat-Tails and Skewness into the Asset Allocation Decision.”
http://corporate.morningstar.com/ib/documents/MethodologyDocuments/IBBAssociates/CVarOptimization.pdf.
