What's new in Asset Allocation

For Banc One Investment Advisors; June 2004

Introduction

Most smart investors have heard that asset allocation -- how they divide their money among investment sectors – generally means more to their portfolio success than any specific investment.  Too often, however, asset allocation is looked upon as a fairly simple process of deciding what percentage to put in equities, and how much to put in bonds.  There is much more to the process, when it is done right.

We believe at Banc One Investment Advisors we've made significant advances in the asset allocation process, building on the groundbreaking research on Portfolio Theory by Nobel prizewinner Harry Markowitz in the 1950s. Truly optimizing a portfolio now involves more than the traditional 60/40 stocks/bonds split.  Some of the new developments, including the use of "downside deviation" rather than "standard deviation" as a measure of risk, were possible only in theory in earlier asset allocation models.  And some of the alternative investments we now consider when developing balanced portfolios have just recently established the kind of history that could make them a legitimate asset class for many investors.

In this paper, we will take a fresh look at asset allocation, and discuss the innovations – including downside risk measurements and use of alternative investments -- we use at Banc One Investment Advisors to customize portfolios and meet investors' goals. Among the topics:

• The importance of asset allocation
• The BOIA asset allocation process and models
• Evolution of portfolio theory
• The real relationship of risk and return
• Downside deviation as a measure of risk
• The place of alternative investments

The importance of asset allocation

The goal of the asset allocation process is to customize the choice of asset classes and their allocations to the investor's requirements and prevailing market conditions. With the proper use of asset allocation, investors and their advisors can avoid the pitfalls of market timing and limit the risk of missing investment targets. With a good allocation, there is less need to try to meet goals with short-term, high-risk bets on particular investments.

Uncertainty is a central reality of financial markets.  As Professor Markowitz noted in his 1990 Nobel lecture, “An investor who knew future returns with certainty would invest in only one security, namely the one with the highest future returns.”  Of course, nobody knows with certainty what investment will have the highest future returns, or when one security will be up and another down.  That brings the need for diversification, and good asset allocation.  If you need proof of uncertainty, check historical returns and you’ll see there is no set pattern. That's why we always say past performance does not guarantee future results.

CHARTS 1-4 (small): COMPARISON OF FIVE YEAR RETURNS - importance of asset allocation - p2 pcspresentation.ppt

In the chart above, when comparing five-year returns for asset classes, we see one five-year period where the Russell 2000 index of small-cap stocks was the best performer, another when the MSCI/EAFE index representing established overseas markets outperformed, another when the high-yield corporate bonds outperformed, and the late 1990s when the S&P 500 index of large stocks was the winner.

But what about the long term? It’s easier to identify asset classes that have outperformed over the long term. However, most investors don’t have a 50-year time horizon, and even if they did, there is no guarantee that an asset class that did well in one 50-year period is going to repeat that outperformance.

Even across 20-year periods, the variance can be great between asset classes. For example, you might have heard that small stocks eventually outperform large stocks. But when you look at 20-year periods (see the graph below), you find that's not always certain. Small stocks did outperform from 1941-1960, and again from 1961-1980, but the large stocks in the S&P 500 beat them from 1981-2000.

CHARTS 5-7 (small): COMPARISON OF 20 YEAR PERIODS - p4 the importance of asset allocation - pcspresentation.ppt

The lesson? Beware when someone tells you with certainty what a single investment or sector is going to do in the future. We address this problem of uncertainty with research, models and good asset allocation.

The Asset Allocation Process

Banc One Investment Advisors has developed an asset allocation process building on traditional theory, real market experience, and some of our own innovations to customize the choice of asset classes and their allocations to the client’s requirements and market conditions.

Extensive research has gone into our asset allocation models. Some of our model portfolio allocations are depicted below CHARTS 8-13: BOIA MODEL PORTFOLIO ALLOCATIONS (latest available), along with our current pre-tax return and risk assumptions CHART 14: Pre-tax return and risk model assumptions - p1 assummptions.ppt or current, with disclaimers if needed)

But the models are just that, models.  For the asset allocation process to work properly, we start with a deep picture of the goals, time horizon and risk tolerance of the client.  The inputs need to be very specific, and clients must be very honest about their goals.  If that happens, we can work together to construct a long-term, well-diversified custom portfolio that meets both the risk and return expectations of the client.  Our portfolio benchmark is the investor's time-specific target, rather than an index or other measurement.  We believe that leads to a better long-term strategy.

CHART 15: Asset Allocation Process - p5 aa-prcs.ppt

In general, we approach asset allocation from a “secular” perspective – that is, a long-term outlook rather than a short-term or cyclical perspective.  That is why you won't see us making the same kind of tactical shifts in our model portfolios as others.  We may make slight shifts in strategic allocations, but don't expect dramatic tactical market calls.

When some advisors speak of “long-term” they are looking at five or perhaps 10 years.  We start with a 25-year-plus time horizon as we look at the market.  However, because not all goals are long-term, and short-term results affect long-term results, we also make judgments about shorter time horizons and keep an eye on economic cycles.

Evolution of portfolio theory

There is a reason the Nobel Prize in Economics is often awarded decades after the research that deserved the prize.  It takes decades to evaluate the connection between theory and reality, particularly in research purporting to show how markets work.  That was the case with Professor Markowitz, whose groundbreaking research on portfolio theory was published in 1959.  He got the Nobel in 1990, when he and others – including the team at Banc One Investment Advisors --had already been building on the original research for three decades.

To put it simply, the prize-winning portfolio theory developed by Markowitz examined how an investor would behave to optimize the returns on a range of investments. “It seemed obvious that investors are concerned with (both) risk and return, and that these should be measured for the portfolio as a whole,” he said in his Nobel lecture.

The Markowitz research focused on “standard deviation” as a measure of volatility and risk to an investment.  The problem, as Markowitz himself noted, is that standard deviation counts as “negative” movements both above and below the mean return for an investment. While it does provide a measure of volatility, in reality most investors don’t mind when their returns are above the mean as opposed to below the mean.  Markowitz acknowledged the drawbacks of using total variance as a measure of risk, and proposed semi-variance, or “downside deviation,” as a more appropriate measure.  Evaluating downside deviation is a more complicated prospect than evaluating standard deviation, and it was thought impossible or at least not practical with the computing power and other resources available in 1959.  Now it is possible – and we are using it at BOIA as what we believe is a more appropriate measure of risk in our asset allocation process. We’ll talk more about its use in asset allocation later in this paper.

The real relationship of risk and return

Some would define risk as the chance of losing money.  We define it as the chance of missing the client's investment target.

One of the great advantages of the asset allocation process is it allows us to look at overall portfolio risk, rather than just the risk of individual investments.  We know with individual investments, higher expected returns come with higher risk.  Diversification reduces uncertainty, or risk, in an overall portfolio - and a well-constructed allocation will limit risk and maximize expected returns.

When the definition of risk is the chance of missing a target - as it is in the real world - a "safe" investment with low return can be the riskiest move of all. Later in our discussion of alternative investments, we’ll explain how adding an extra asset class – even one with higher risk as a class – can reduce the overall risk of a portfolio.

For example, if we use standard deviation as our measurement of portfolio risk, U.S. Treasury Bills would be a low-risk investment relative to large-capitalization stocks. But for a client with a 9 percent investment objective and a 10-year time horizon, investing in Treasury Bills is more likely to lead to a shortfall from the objective than investing in large-cap stocks. In this example, the Treasury Bills have greater downside risk. In other words, the risk of not meeting the investor’s objective is greater.

CHART 16 - An example of downside deviation - p4 AssetAllocationMethodology.ppt

Downside deviation as a measure of risk

We believe using downside deviation rather than standard deviation gives us - and our clients - a competitive advantage. It allows us to focus on the client's target rate of return, rather than the average return, allows us to look at a client's time horizon rather than the one-year horizon assumed in standard deviation, and allows us to look at the risk that really matters to an investor.

When financial theorists measure risk with standard deviation, they are looking at volatility around the mean - in other words, returns that are 10 percent above the mean count as negatives just as returns that are 10 percent below the mean.  In the real world, when investors think of risk they only really worry about the returns below expectations.

When asset allocation theory began to be applied to real-world portfolios, the computing power and historical data sets weren't available to use downside deviation.  Standard deviation became, well, standard, as a measurement of risk.  Now we have the computer power, and the data from a sufficient historical time period, to be able to consider downside deviation as a better measure of risk to a real portfolio.  With our process, we are able to measure - for a custom portfolio - the probability of shortfalls below the client's goals. While many in the industry are happy with the tools they have used for years, since the mid-1990s we have customized software, added proprietary information and research, and come up with what we think is a better way of looking at portfolio risk.

The technical measure is downside deviation, similar to the semi-variance deviation Professor Markowitz spoke about. It takes into account both the magnitude and probability of shortfall versus a target - the target being the investor’s time-specific goal rather than the mean return.  It's also important to note here that a longer investment horizon reduces the downside risk.

The place of alternative investments

We also believe we offer a better asset allocation model because we include for consideration a wider range of asset classes - including alternative investments such as hedge funds, REITs and market neutral funds.  To develop a truly balanced approach, and a truly diversified portfolio, we think it’s important to include alternatives to traditional stocks and bonds.

Alternative investments play a key and growing role in good asset allocation by enhancing returns or reducing overall portfolio risk.  More important, they may give a portfolio returns at times that traditional investments are lagging.

Part of the risk of limiting asset class choices to stocks and bonds can be better explained with the concept of correlation.  That is, while stocks and bonds are often considered opposites, in many cases their returns can move in the same direction at the same time.  By adding non-correlated alternative investments to the mix - even asset classes that may be considered higher-risk on their own - a well-constructed portfolio can reduce overall downside risk.

CHART 17 - A case of perfect negative correlation - p7 pcspresentation.ppt

An analogy might help. Think of having different vehicles that serve different purposes in your household or business.  With traditional asset allocation, you might have an SUV for winter driving and a sports car for summer driving.  But what if you need to pick up a load of mulch? A pickup truck might come in handy every now and then.  That's something like how we see the place of alternative investments in a portfolio - they may play a smaller role, but it's an important role.

The right balance

The key for the investor is to find the right balance of assets to suit your investment goals and your own appetite for risk. Finding the right mix can enhance your long-term growth potential while limiting the downside risk. For example, in the diagram on page … we showed how T-Bills have more downside risk than the S&P 500 to an investor with a 9% investment return objective. However, that doesn’t mean that investor should discard T-bills altogether and put all their money in the S&P 500.

By mixing Treasury bills and stocks, the downside risk of the portfolio would have been even less than the downside risk of an all-stock portfolio. And by adding other asset classes such as international stocks, high-yield corporate bonds and market-neutral funds, the downside risk would be even lower and the chance of meeting your investment objectives would be greater. The asset allocation models on page … are examples of how an investor might construct a portfolio based on your own objectives and risk tolerance. A Banc One Investment Advisors consultant can help you come up with your own ideal balance of risk and return, and then plot an asset allocation model designed to give the maximum likelihood of accomplishing those objectives.

What's next?

Just as we watch portfolios to rebalance, we are constantly monitoring our asset allocation models and assumptions.  Our asset allocation committee - managers from all investment areas plus our chief economist - meets at least eight times a year to review our process, what others are doing, and the latest research inside and outside the firm.

While there is a constant review of the process, that's not to say there are constant changes.  When we do come up with new ideas, they are tested and based on what we see actually happening in the markets, rather than the hot theory of the day.  For instance, while we believe alternative investments have a place in a balanced portfolio, we want significant history and information before we are comfortable enough with a new asset class to consider adding it to the mix.

And once you choose your own asset allocation mix, you too need to keep track of those investments and to rebalance them periodically – generally twice a year is a good rule. Not only do the prospects for asset classes change over time, but the chances of meeting your objectives is also likely to fluctuate. For example, let’s say your investment objective is to gain an average of 9.5 percent a year over the next 25 years. To meet that goal, you’ll need to accept a certain level of risk. But three years later you notice your portfolio has gained not just 9.5 percent a year but 12 percent a year. As a result, if you were to continue with the same asset allocation mix you would now be assuming greater risk than you would need in order to meet your objectives.