The objective when combining asset classes is to select ones that exhibit low correlation to one another. The concept is to select asset classes that do not move lockstep with one another as the financial markets change. In statistical terminology, this implies a low correlation coefficient(Figure 7.3).
Here’s an example of how this works: Let’s examine the period from 1982 to 2001 and track the best-performing sector, and then match it against the 92 THE PROCESS
worst-performing sector in each year. This is an interesting period of time because in 1982 foreign stocks were the worst-performing sector, but in 1983, they were the best sector. Government bonds were the worst-performing sec- tor in 1983, but the top category in 1984.
If you’d been 100 percent invested in stocks over the 1982 to 2001 time frame, you would have averaged 11.2 percent, and you would have had seven down years. If you’d been 100 percent in bonds, you would have averaged 8.7 percent and you would have had six down years. But had you allocated your assets 60/40 percent in stocks and bonds, respectively, you would have aver- aged 10.5 percent, with only three down years. If you’d been invested one- third each in stocks, bonds, and cash, you’d have averaged 9.6 percent and had two down years.
This is one way of explaining asset allocations and how it can remove some of the bumps, or down years.
This raises the question of what percentages in what asset classes?This is where experience helps. Yes, it depends on risk tolerance, time horizon, and all the millions of little nuances, but sometimes it just comes down to filling a gap (why we do financial planning). If your client says he/she needs to accu- mulate more assets to retire and can stomach it, you’ll have to add more risk to achieve greater returns.
The following are two basic approaches to asset allocation: (1) the style box approach, and (2) the core/satellite approach. Equity style boxes have been popularized by Morningstar, the ubiquitous mutual fund rating organi- zation. Morningstar’s style box, started in 1992, features nine boxes in a tic- tac-toe grid, as shown here.
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Time
Value
Portfolio A Portfolio B
FIGURE7.3 Portfolios That Have a Negative Covariance.The Two Portfolios Move Inversely.
Unless a client’s total portfolio is well over $1 million, it is difficult to get adequate diversification with the style box approach unless either (1) mutual funds are used for the smaller allocations, or (2) some categories are elimi- nated or combined (e.g., creating a small/midgrowth allocation).
Using the style box approach creates numerous questions: What happens when a manager drifts into a different style box? How often do I rebalance?
Do I need to use all nine boxes? There is little that can be done with a man- ager who drifts into different boxes other than replacing that manager with one who is more style adherent. Or, as an alternative, you could use a core/satellite approach.
A core/satellite approach entails creating a portfolio that has as its foun- dation a core equity fund or strategy that serves as the anchor. This core equity position generally includes both value and growth-type investments, and focuses primarily on the highest quality of companies with the least amount of risk. After the core position is established, the other, more aggres- sive equity strategies can be added as satellites to the portfolio.
Either approach requires relatively large asset positions in order to prop- erly fill all the boxes or satellites. In many cases, by using a combination of funds and separately managed accounts, you can have access to virtually every asset class while also retaining some level of control over the clients’
tax situation. For many advisors, this is the best of both worlds. Some great fund managers do not offer separate accounts or have extremely high mini- mum account sizes, but their product can be accessed through mutual funds.
Some managers specialize in the separate accounts business, and do not have a fund offering. In some cases, a desirable manager may run a fund with a lot of imbedded tax gains, but a comparable product is offered on the separate account side of the business without built-in tax liability.
The obvious way to combine boxes is to collapse the small and midcapital- ization categories together, leaving the advisor with six boxes to fill. The result, assuming the managers are well selected, should give the client most of the benefit of the style box diversification without the additional resources required to fill all nine boxes.
There are multiple methods to eliminating boxes. The easiest is to simply 94 THE PROCESS
Large value Large blend Large growth
Mid value Midblend Midgrowth
Small value Small blend Small growth
remove the center column (i.e., the “blend” column) and allocate assets to the remaining six boxes. If the center column andthe center row are eliminated, the result is the original style box, which has been used informally for decades:
Large value Large growth
Small value Small growth
This is an excellent approach for clients with fewer assets. Many investors have a bias toward growth or value, which can be incorporated into the asset allocation by eliminating a couple of boxes from the “value” or “growth”
columns. For example, if Mr. Jones tells you that he is a risk-averse value investor, you might use “Large value,” “Small value,” “Midblend,” and “Large growth.” This allocation favors his bias, while insuring participation in the growth part of the equity market (albeit the least volatile of the growth sub- categories).
The core/satellite approach is based on the philosophy that managers should manage the money the best that they can, and advisors monitor the managers. The premise of this approach is that each client has a core portfolio allocation, and then some satellite allocations. Constructing a core portfolio is challenging, but rewarding (see Chapter 9). The core portfolio is characterized by diversification, low volatility, and market participation. Managers are more likely to describe their own investing philosophy in terms of style (“growth” or
“value”) rather than size (“small cap” or “large cap”). With this in mind, the core of an asset allocation would include a fixed-income portion, a growth portion, and a value portion. Usually, the equity managers used are the go- anywhere type of manager (i.e., a manager who does not follow the capital- ization constraints inherent in the style box approach.
The satellite aspect of the allocation can be used in a variety of ways. Some advisors like to tilt client portfolios toward certain asset classes at different times, and use a relatively active asset allocation strategy. The core/satellite approach supports this approach by allowing an advisor to create smaller satellite allocations that can be used to add value to the overall portfolio. By maintaining the bulk of the assets in the core allocation, both the client and the advisor are protected in the event of a poor timing decision. Often, the client or the advisor strongly favors a certain manager or market niche. This could prove to be an excellent complement to the core holdings, providing additional diversification.
For instance, a client might receive a recommendation of:
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Multiple separate account managers could be recommended for each capital market segment. If the investor has adequate assets, up to six different sepa- rate account managers might be recommended to properly diversify. If the investor has fewer assets, the recommendation would probably roll up the segments into the three broad categories using three different separate account managers plus a few mutual funds.