ITA Wealth Management

Asset allocation, sometimes known as “The Endowment Model,” is under criticism by some quarters in that there seemed to be no place to hide in the latest bear market.  Even hedge funds, designed to prevent huge portfolio declines, failed over the last year.  A number of hedge funds turned off the lights.  The demise of ten were listed in the Thursday issue of the Oregonian newspaper.  The simple question we ask is, should we continue to follow the asset allocation model?

The asset allocation model described and followed in this blog differs from the Endowment Model in that as small investors we do not have access to venture capital and private equity options.  These esoteric investment vehicles are only available to large pension and endowment funds, and even there, it is the very largest endowments that can hire the top quartile of money managers.  Since most of us are not playing in that league, we settle for asset classes where we have access through the use of Exchange Trade Funds (ETFs).

To answer that simple question, should we continue constructing portfolios around the concept of asset allocation, my answer is — Yes!  Even this brutal bear market has not changed my opinion of Ibbotson & Associates research where they state — “On average, about 100% of the return amount is explained by asset allocation policy. This is so because, on average, active management adds nothing. This does not say you should not use active management.  We are talking about averages, and on average active management adds nothing.”  The portfolios tracked over on the Premium Content side of this blog generally use from eight to twelve basic asset classes.  They include the “Big Six” equity asset classes, REITs, international (developed countries), emerging markets, commodities, bonds, and cash.  The greatest variation between the different portfolios shows up in how one chooses to populate the international and emerging markets.  For guidance in these areas, we use a software program called Quantext Portfolio Planner (QPP).  In past posts, I’ve shown bits and pieces of this spreadsheet program.

The first step of selecting the different asset classes is not all that difficult.  Selecting the percentage to assign to each asset class is the much larger problem.  We have several choices in this decision.  1) We can go to books and web sites for percentage guidance.  That is how I did it when I first began to build portfolios using asset allocation.  2) We can analyze different asset classes through the use of QPP and use those projected returns as guidance for increasing percentages in those asset classes that provide the greatest return while reducing risk.  Or at least we have a better sense of the risk we are taking when we attempt to increase the projected return. 3) We can apply some Seasonal Tactical Asset Allocation (STAA) when we deem the situation calls for moving the allocation levers in a particular direction.

There is no absolute answer to which tack one should take when building a portfolio.  We will continue to use ten to twelve asset classes to put together portfolios.  Then we will use every bit of information possible to come up with the best percentage for each asset class that generates an acceptable combination of projected return, risk reduction, and portfolio diversification.

Lowell Herr

Photograph: Wales woman carding wool.

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