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Efficiently Harnessing Market Returns for Investors.

Asset Allocation and its Importance

Ironically, when investors talk to their investment advisors, much of the conversation is about:

This way of thinking, although important, should take a back seat to the most significant impact on portfolio performance, asset allocation. Why? According to a Brinson study;

Asset allocation determines over 90% of a portfolio's return variability

Brinson, Hood, and Beebower

What is asset allocation? The investment allocation to and between the main categories of:

Considering this decision will have a major impact on returns, we believe investors should have a clear understanding of how their advisors go about formulating asset allocation. Investors can use several methods to determine asset class exposures over a given period of time: Strategic Allocation, Tactical Allocation, and Market Timing.

Definitions

Strategic Allocation-
The long-term static allocation to asset classes based on maximizing risk-adjusted return consistent with the investor's objectives.
Tactical Allocation-
The dynamic prediction of asset class performance and the corresponding movement of money between the classes in favor of the assets expected to do better, disfavoring the assets expected to do worse.
Market Timing-
The most active movement into and out of asset classes, usually versus cash, in an attempt to time when the asset classes will perform better and worse in the short run.

What Most Advisors Do

Advisors often will blend a form of strategic and tactical allocation into a portfolio. While they may believe they will be able to add value by doing this, it has an additional effect on the portfolio that is important for investors to know. It gives the appearance that the advisor is doing more, which makes it easier to justify charging clients higher fees.

Strategic Allocation

In order to understand if any value is actively being added, it's important to understand the differences in these models. Here we will mostly focus on the various forms of strategic allocation and summarize the primary models, which we view as:

Tactical Allocation

Unfortunately, like many areas within investment markets, the more the investment industry can convolute the understanding, categorizing, classifying, or measuring, of a particular area, the more the manager will try to justify higher fees from clients. Tactical asset allocation is one of those areas. There are as many models, categories, and strategies as you can think of. Therefore, we will simply say "buyer beware." If you can't simply understand what your manager is doing, we'd suggest not doing it at all.

Market Timing Strategies

Market Timing Strategies, like Tactical Allocation Strategies, should be thought of in application as more art than science. However, we can demonstrate that the incentives to properly market time are significant. In this case, if someone were actually able to market time by taking the better of the S&P 500 or cash returns each quarter for 30 years, $1 million would turn into about $400 million, 20 times the buy and hold stock return strategy. See Spreadsheet.

Market Timing

It is no wonder that many investors attempt to cash in on such a strategy. Yet the results consistently show that on a risk-adjusted basis these strategies underperform a well-balanced, highly diversified, strategic allocation over time.

As we think about the foundation for strategic allocation techniques, let' take a look at Harry Markowitz's Mean Variance Optimization (MVO) model and the Capital Asset Pricing Model (CAPM) developed by William Sharpe.

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