Asset allocation was considered the Holy Grail of investing back in the 1990 during one of the strongest bull markets on record. The concept of building a portfolio using a wide variety of asset classes received a boost after the Brinson et al. papers were published in 1986 with a followup in 1991. Over the last twenty-five years the “asset allocation glow” has dimmed, largely due to research by Ibbotson. Here is one of their latest papers that summarizes their conclusions.
“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 (2010) showed that active management has about the same impact on performance as a fund’s specific asset allocation policy.”
Setting the Record Straight on Asset Allocation is another paper readers will find useful. There are a number of interesting links embedded in this article.
For ITA readers following the Portfolio Performance data published nearly every Saturday, we are running our own tests on asset allocation and in several cases, adding a momentum component. You can see how well the various portfolios perform with respect to the ITA Index. Updating the table this morning, eight of the fourteen portfolios are outperforming the ITA Index. Fifty-seven (57%) percent does not tell the whole story. Two portfolios (Copernicus and Pasteur) are new and as yet not fully populated. Both are under-performing their respective ITA Index IRR percentages. While I don’t have the latest data, if we add the Hawking and Rutherford portfolios, we move the percentage needle up to 62.5%. Sixty-two (62.5%) is beginning to look like a slight edge over a passive ITA Index strategy. If we combine the portfolios that are outperforming the ITA Index with those portfolios that are producing a positive trend compared to the performance six weeks ago, the percentage jumps from 57% up to 85.7% (excluding Hawking and Rutherford). If I can hold that percentage above 75% I’ll argue there is something valuable in using a Strategic Asset Allocation model combine with a momentum strategy.
The closer a portfolio aligns with the target percentages in the various asset classes found in a Dashboard, the closer the Internal Rate of Return (IRR) for a portfolio will match the ITA Index IRR. The ITA Index uses the IRR of the critical ETFs and the target percentage in each asset class to come up an IRR value.
As Ibbotson points out, “asset allocation is very important,” particularly if one uses low correlated asset classes. Global diversification is another advantage when building a portfolio as one is “forced” to consider investments outside the United States. We all know how provincial U.S. investors can be.
Caution: We have yet to test the SAA plus momentum strategy in a vicious bear market. The expectation is that volatility will be contained by using the SHY and ITARR cutoff models. It really depends on how quickly the bear strikes as our models are set up to work better in sustained downward markets rather than very sharp declines.