| Richard
Newell
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Academics
and theoreticians believe is it possible to take the theory
of asset allocation and apply it to the creation of an efficient
investment portfolio, one that provides the correct balance
of risk and reward for each client. Unfortunately, in the real
world, values are not constant and the average investor or financial
planner does not have the ability to maintain an efficient portfolio
at all times. Indeed, many planners have begun to openly question
the theory.
Their lack of appreciation has been highlighted by two of New
Zealand's top finance academics, Ed Vos, associate professor
of finance at Waikato University and Francis Milner, a corporate
finance analyst with the BNZ. Their original 2002 report, 'The
Theory and Practice of Investment Advice in Financial Planning'
concluded that advisers are not putting forward theoretically
good advice, because they lack the ability to appreciate how
to adjust portfolios according to changes in the clients' risk
tolerance. That is, they do not think in terms of investing
in the optimal 'market portfolio' and matching this with 'risk
free' holdings.
From the academic view, it is symptomatic of a lack of understanding
of the concept. Advisers though, don't see it that way. They
believe the theory is just that, a theory, and that in the real
world, there are other ways of formulating asset allocation.
Generally, strategic asset allocation considers long term return
expectations for different asset classes, their risk characteristics
and correlation. The aspirations, well-being and risk tolerance
of the investor also play a role. The combination of the risk
asset and risk-free assets is the basis for the theory of efficient
portfolios. The father of modern portfolio theory, Harry Markowitz,
established the concept of the efficient portfolio; one that
maximises expected return while minimising risk. Taking into
account all the potential combinations of assets, it is possible
to determine which portfolios provide the greatest expected
return for a given level of risk. The efficient frontier is
then created by plotting all efficient portfolios on a single
graph.
James Tobin extended Markowitz's thinking by introducing the
concept of risk-free assets. Tobin found that by introducing
a risk-free asset into the model, a single portfolio along the
efficient frontier could be established as the optimal portfolio.
This so-called 'market portfolio' was embraced as the most appropriate
basket of risk assets for all investors, no matter what their
level of risk tolerance. The relative proportions of assets
within the basket would not change. What investors needed to
determine was how much they would invest at the risk-free rate
and how much in the market portfolio.
Vos and Milner explain: "Therefore, customising a portfolio
of assets to an individual client's risk/return preference is
not a matter of changing assets or weightings within the risky
basket. It is a matter of choosing between the risk free rate
and market portfolio." This equally applies to an aggressive
investor who wants to move further up the capital market line
from the market portfolio (higher expected return) by borrowing
to invest. "Any other choice does not optimise the parameters
of risk and return," say Vos and Milner.
The process of formulating a client's long term strategic asset
allocation is one of the most important, if not the most important
component of the whole advice process. If, as has been suggested,
asset allocation is responsible for 90% of investment performance,
why is the efficient portfolio theory not taken more seriously?
Unfortunately, the theory has come under severe criticism over
the course of the recent bear market. Norman Stacey of Diversified
Investment Strategies, is just one of many advisers who do not
have much time for the academic viewpoint: "The efficient
portfolio theory has failed investors over the last three years.
It has not provided them with a way through the bear market
we have just been through. That is perhaps the issue for the
academics to address.
"The bear market has shown that it is market risk that
many clients and even advisers cannot handle. The volatile conditions
have scared off a lot of investors."
Economist Donal Curtin also has issues with the efficient portfolio
theory. In particular, he questions the validity of adherence
to efficient portfolios based on false assumptions: "It's
quite clear that the idea of a stable set of correlation coefficients
is simply wrong."
Curtin believes that relying heavily
on traditional strategic asset allocation methods may not be
appropriate for many clients. "This is true over a variety
of different time periods. If we look at asset class performance
over the last 11 years, property is at the top and equities
are at the bottom." There is still scope for using the
principles of modern portfolio theory, but Curtin's view is
that "it is possible to structure an inefficient portfolio
based on false assumptions."
Vos has produced other research* that supports his view that:
"low and stable correlations are very possible. But care
must be taken as to the proper specific investment within a
class." He defends his position by reiterating that his
paper was attempting to ascertain where advisers are failing
to firstly understand theory and secondly implement it: "The
theory does not say that they 'must find stable low correlations'
or that they cannot, from time to time, based on their expert
analysis of expected returns, co-variances, and standard deviations,
change their minds about what they see as 'their best shot'.
Everyone receiving their advice should get the same opinion
at the same time.
"So, the recommended mix of what is in the risky basket
of investments can, and will, change from time to time. But
the proportion of what is in that mix should not change as the
client's risk profile changes."
One criticism levelled at the theory is that traditional beliefs
about diversification have not held up, that in the bear market
situation, all major markets are highly correlated. But Vos
says it is not correct to suggest that asset correlations are
all high in bear markets: "This is just another example
of people not being willing to undertake the necessary research
and analysis to create optimal portfolios.
"Planners seem to feel that the mathematics of diversification
are no longer valid. I can prove to you that diversification
reduces variability. If planners are not up to using the maths,
this is one thing. But if they reject the math as 'not valid'
this is quite wrong. My paper only suggests that they should
use the math and then come up with their 'best shot'."
Clearly there is a credibility gap between the theory and the
practice. Strictly adhered to, the efficient portfolio model
should work and, as such, there is risk for the client in not
applying it. Do advisers have the tools at their disposal to
bridge this gap? In terms of asset allocation, they rely heavily
on their product suppliers. And in terms of risk assessment,
no they don't have the tools. For many clients, the concept
of investment risk is something they have learned about the
hard way.
The problem of defining a client's tolerance was illustrated
by a controlled study of risk assessment carried out by advisers
in Australia. It was shown that advisers' estimates would have
been more accurate if they had made no attempt to understand
their clients' risk tolerance, but had simply assumed all were
average. This is not a criticism of advisers. Other studies
involving managers and subordinates, doctors and patients, teachers
and students, etc. have shown similar inaccuracies in assessing
personal attributes. Where the industry has failed is in not
using the available knowledge to devise more effective methods
of investment risk assessment.
Donal Curtin encourages investment advisers to think outside
the box when formulating client asset allocation. "The
industry trend is to follow your favourite investment managers
of the moment, for example Wellington, or Alliance Capital and
just vary the weighting according to the client. A better practice
is to use different funds in different proportions across different
risk profiles, rather than the same fund manager in different
proportions for all levels of client."
Not unnaturally, Curtin does not follow the advice of the academics:
"No, I am guilty on all counts there," he says. "I
am prepared to make strategic shifts in asset allocation. And
as an economist, I like to think I have information that will
be some guide to the way things are going, so I'm prepared to
make the tactical calls. I am also happy to make changes in
style and to replace fund managers."
Diversified Investment Strategies are also firmly in the active
asset allocation camp: "It adds value and reduces risk,"
says Stacey. He recognises the complexity of the issue and that
misinterpretation, or 'shibboleths' are apt to confuse the issue.
For example, the oft-quoted theory, originally put forward by
Brinson, Singer and Beebower, that over 90% of the return of
a portfolio could be explained by its asset allocation. What
Brinson's research actually indicated ws that 90% of the variability
of fund performance was due to asset allocation. More recent
research by Ibbotson Associates suggests the return attributable
to asset allocation is more like 40% for mutual funds and 35%
for pension funds. The remaining 60% of fund performance variation
results from such other factors as the timing of moves between
asset classes, security style (e.g. value or growth stock),
security selection and expenses.
So, the view put forward by Ed Vos is an idealised one, where
advisers are constantly monitoring the efficient frontier and
the capital asset pricing model in order to structure the most
efficient portfolio at that time. The advisers' view is that
they don't trust the theory and besides, they don't have time
to seek out the optimal solutions.
There would appear to be some consensus here, that the complexity
of trying to aggregate various assets to come up with an optimal
risk/return profile is beyond the scope of most advisers. Vos
and Milner's research confirms this and industry evidence suggests
that advice is proffered on the basis of a set menu of investment
options that can only approximate an optimal portfolio.
Vos maintains that "the goal of an 'optimal' portfolio
using mathematics is still valid, and all clients should get
the same advice. This does not mean that the opinion of optimal
cannot change. Indeed, it should as more products become available
to enhance the 'optimal' performance."
Further reading:
Theory and Practice of Investment Advice in Financial Planning,
Ed Vos and Francis Milner, University of Auckland Business Review,
Vol 4, No.2 2002.
Macroeconomic Drivers of the Non-correlation Between Equity
and Commodity Indices. Co Author: Frank Aarts. The Global Business
and Finance Research Conference. London, Vol 1 No 1, pp 380-393.
14-17 July.
Private Equity: A Portfolio Approach, Francis Milner and Ed
Vos. Journal of Alternative Investments. Vol 5 No 4, Spring
2003. pp 51-65.
Does Asset Allocation Policy Explain 40,90 or 100 per cent of
Performance? Roger Ibbotson and Paul Kaplan. www.ibbotson.com
If you would
like to know more, please send
me an e-mail. |
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| Copyright 2003-2007
Richard Newell. All rights reserved. |
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