
I am in the process of reading Christopher L. Jones’ book, “The Intelligent Portfolio.” In a way, this book was written to chum for Financial Engines clients as there is a one-year promo for FE that comes with the book.
Two points are standing out in the book at the moment. One begins on page 189 where Jones warns readers of why hierarchical asset allocation is bad for portfolios. Hierarchical asset allocation is where one first sets up portfolio asset allocations and then funds those asset classes with actively managed mutual funds, index mutual funds, ETFs, bonds, stocks, etc. Jones writes about the danger of forcing poorly managed or expensive funds into an asset class simply because it is not funded. Instead, one should pick the best funds and then tweak the allocation around those funds. Wrong!
For those of you who have kept up with this blog, you know that setting up allocation percentages is one of the very first steps in portfolio planning. I am puzzled as to why ETFs were not used as an alternative to portfolio development.
Where Jones is wrong on this point, in my opinion, is that he seems oblivious to the wide array of index funds and ETFs one can use to populate a portfolio. While he does mention ETFs elsewhere in the book, he views them mainly as the “new kid on the block.” Instead of using low cost index funds and/or ETFs, he seems hitched to actively managed mutual funds. Jones devotes one chapter to “Picking the Good Ones,” where he provides guidance for selecting funds. I will need to hold my nose as I read this chapter. Other readers may have a different take on pages 189-193. In this section he also uses the Brinson et. al. studies, but fails to mention the Ibbotson & Associates studies that answered the questions he criticizes Brinson for not answering. If you missed the Ibbotson material, just do a search and read all those posts.
Another area I question comes out of the Financial Engines (FE) optimization model and that is where he tells us growth will outperform value. My data tells me the reverse is true. Maybe the FE model is spotting something going forward that most of us fail to see. I have yet to run into the notion that rebalancing is unnecessary, but I understand from the reviews it is there.
Jones talks a lot about the “Market Portfolio,” a 15-asset class portfolio that covers just about everything except international REITs and commodities. What I found very interesting is how little one gives up in projected return by not including many of the asset classes. This is due to the fact that most of the 15-asset classes are highly correlated. If one combines several asset classes, FE comes up with similar future projected returns. This section of the book certainly makes the case for portfolio simplicity.
If I were to list the 15 asset classes and ask 100 people what asset class, if removed from the portfolio, will result in the maximum loss of expected return, I’ll bet not more than one or two percent would get it right. Anyone want to take a guess?
Lowell Herr
Photograph: Lily from our front yard
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