The asset allocation decision is the most important one for foundations. Studies show that 80% – 90% of investment return comes from asset allocation versus manager selection. In spite of these studies, foundation investment committees spend more time evaluating and changing money managers than they do evaluating and adjusting asset allocation. Good money managers do add value (alpha), but not as much as asset allocation. The recent market volatility has raised questions about the best way to pursue asset allocation.
Historically foundations have set a long-term asset allocation (strategic asset allocation) and rebalanced their portfolio back to this allocation periodically. The conviction to do this was grounded on work done by Harry Markowitz, Ph.D. and what is called Modern Portfolio Theory (MPT), which he explained in his 1959 book called Portfolio Selection: Efficient Diversification of Investments. He won the Nobel Prize in 1990 for his work. MPT is widely used in practice in the financial industry. MPT is a theory of finance which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets.
MPT is a mathematical formulation of the concept of diversification in investing, with the aim of selecting a collection of investment assets that has collectively lower risk than any individual asset. That this is possible can be seen intuitively because different types of assets often change in value in opposite ways. For example, to the extent that prices in the stock market move differently from prices in the bond market, a collection of both types of assets can, in theory, face lower overall risks than either individually. But diversification lowers risk even if assets’ returns are not negatively correlated – indeed even if they are positively correlated.
More technically, MPT models an asset’s return as a normally distributed function, defines risks as the standard deviation of return, and models a portfolio as a weighted combination of assets, so that the return of a portfolio is the weighted combination of the assets’ returns. By combining different assets whose returns are not perfectly positively correlated, MPT seeks to reduce the total variance of the portfolio return. MPT also assumes that investors are rational and markets are efficient.
MPT was developed in the 1950s through the early 1970s and was considered an important advance in the mathematical modeling of finance. Since then theoretical and practical criticisms have been leveled against it. These include the fact that financial returns do not follow any symmetric distribution, and that correlations between asset classes are not fixed but can vary depending on external events (like crises). Further, there is growing evidence that investors are not rational and markets are not efficient.
Although MPT is the standard used in the investment industry and is used at Monroe Vos, we believe that there are macro-economic forces and human nature (greed and fear) that cause markets to not be efficient at times and investors to not be rational at times. We believe that MPT used to structure portfolios for the long run is a viable concept, but in the short run some range of asset allocation around the strategic is worth considering.
Dynamic Asset Allocation
Monroe Vos started using Dynamic Asset Allocation (DAA) in 2000 before the tech bubble burst. At that time we recommended a move from whatever percentage clients had in stocks to a 40% allocation to stocks and a 60% allocation to bonds. This 20% move helped protect portfolios during the bursting of the tech bubble.
We believe that it is important to incorporate DAA into investment programs by: 1) More frequent review and adjustment of asset allocations using market-driven assumptions; 2) Incorporating bands for each asset class around the Strategic Allocation which allows for changes in allocation within the bands to reduce risks or be opportunistic by increasing the allocation of an asset class; and 3) Delegating a portion of the assets to alternatives when the opportunity presents itself.
Implementing DAA may require some changes to program governance such as an expedited committee decision-making process, delegating specific authorities to staff, or structured changes to include opportunistic and global flexible components of the strategic asset allocation. Broadening policy bands can be an important part of allowing for more dynamic asset allocation, as well as ensuring that rebalancing is less “mechanical” and more flexible to allow for adjusting allocation based on changing market relationships.
A dynamic approach to asset allocation creates an opportunity for long-term investment programs to increase return and manage risks more effectively. We believe that with more frequent reviewing and adjusting asset allocation, incorporating opportunistic investing, and employing flexible strategies, investment programs can pursue these important objectives without engaging in short-term “market timing”. A dynamic approach to asset allocation can serve to focus investment committees and program staff on important, but often overlooked, drivers of risk and return like asset allocation.
In the challenging global investment environment characterized by muted expected capital market returns and outsized potential risk, we believe it is critical for investors to employ every tool available to them. As markets continue to evolve, we expect that Dynamic Asset Allocation will become an increasingly important component of investment program oversight.
Jamison Monroe, CIMA®
Chairman & CEO
Released: May 10th, 2012 11:49 AM