Jan 12
Asset Allocation Revisited
If any single concept were the focal point of this blog it would be Asset Allocation. Therefore, it is time to review this all important topic. While each investor will set up an asset allocation plan to fit their financial needs, we do need to be reminded that too many folks pay little if any attention to this all important application of investing.
Strategic Asset Allocation (SAA) is the “normal’ mix of assets given the objectives of individual investors and their willingness to accept certain levels of risk. The AEM portfolio is one of the best examples I know where the portfolio is made up of a basic group of ETFs with no tilting of the asset classes. In other words, value and growth are given equal weight and the portfolio does not stray too far from the very basic asset classes. The portfolio is skewed slightly toward smaller cap stocks and the percentage allocated to bonds (5%) is a rather aggressive posture. Otherwise, the AEM portfolio is a very basic SAA style portfolio.
The AEM portfolio follows a rebalancing discipline so it is not a buy and hold portfolio. The portfolio is easy to understand and implement. The asset classes all have R-Squared values within 70% of the S&P 500 so the portfolio returns will align with those of the S&P 500.
If we move away from SAA and apply a little activity to our asset allocations, we will end up with something closer to the Passive Portfolio (PP). Active asset allocation is sometimes called Dynamic Asset Allocation (DAA). Note: Details of the AEM and PP are laid out on the Premium Content side of this blog. Active management with the PP is confined to portfolio tilt. This tilt toward value was established back in 2000 when the portfolio was launched. The PP asset plan is skewed toward value and small & mid-cap size. The reason for this is based largely on the research of Fama & French. One also sees the F & F influence in the make-up of the DFA funds and the portfolios one sees on the IFA web site. DAA sometimes takes on movement between equities and bonds. The PP is not such a portfolio. Activity took place when the portfolio was born and that decision remains in place today, eight years later.
Tactical Asset Allocation (TAA) is our third and most aggressive approach to this general subject. Many wise advisors tell investors to stay completely away from TAA as it is nothing more than market timing and it flies in the face of the efficient market theory. In general, I agree with that point of view. However, within the last year I came across a new software tool called Quantext Portfolio Planner (QPP). Using reversion-to-the-mean techniques, this software aids the user in making projections as to which ETF or stock is likely to generate a higher return. In addition, one can see how correlated the investment is with the S&P 500 and what risk is involved in setting up a portfolio with a particular asset mix.
Of the seven portfolios tracked over on Premium, five are still holding cash positions. Little by little that cash is being invested. The approach I am taking with each portfolio is a combination of the three basic strategies, with a little more emphasis on DAA and TAA. Thus far all five portfolios are performing better than the VTSMX benchmark, but all data is in the infant stages and therefore not conclusive. All we can say at this point is that the budding results are positive for an approach that relies on strategic asset allocation, rebalancing, and tinged with a little tactical asset allocation.
Lowell Herr
Photograph: Ship leaving Dubrovnik, Croatia
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Sphere: Related Content
January 12th, 2009 at 7:52 am
Lowell,
Let me raise a question: Is not rebalancing a version of reversion to the mean TTA?
Bob Warasila
January 12th, 2009 at 9:10 am
Bob,
Did you mean TTA to be TAA? I’ll answer as if you mean it to be TAA.
I separate rebalancing and Tactical Asset Allocation. Rebalancing is somewhat mechanical in that one sells assets when the percentage of a particular class of assets moves outside its upper boundary or target limit. Those resources are then applied to any asset class that is under target or to those asset classes that are most under target. Rebalancing happens less frequently than most investors realize. At least that is my experience.
On the other hand, Tactical Asset Allocation (TAA) is when the investor is taking advantage of what they perceive to be inefficiencies in the market. One line of thinking tells us this rarely happens and when it does, investors are not smart enough to realize it, so it does not pay to time the market, even to the slightest degree. If one engages in TAA, the investor may use business cycles, interest rate outlooks, technical analysis, dividend discount methods, or as the QPP software does, analyzing the volatility of an investment to make reversion-to-the-mean projections.
Let me quote from Roger Gibson’s book, Asset Allocation, page 279 of my version.
“With less than truly superior predictive ability, it is quite easy for an active asset allocation strategy to provide returns inferior to those available with passive asset allocation approaches. For this reason, if active asset allocation strategies are employed, it is wise to establish minimum and maximum allocation limits for each asset class. This will ensure some minimum level of portfolio diversification and limit the potential for problems associated with an overcommitment to any single asset class.”
This morning I am going to provide a rather thorough look at the AA-Mosaic Portfolio over on Premium Content. I will try to explain how I intend to use TAA, with help from Quantext Portfolio Planner (QPP) while following Gibson’s suggestion above.
I hope I answered your question. If not, press me to elaborate.
Lowell