ITA Wealth Management

Photograph: Mt. Hood, OR – Photograph by my good friend, Wayne Gingerich

If you have questions why the AA-Mosaic Portfolio includes so many asset classes, just read the referenced article, “The Benefits of Low Correlation.”

After reading this article, I had second thoughts about allocating only 5% to commodities. However, 5% should be adequate due to our emphasis on value and small-cap stocks as well as participating in emerging markets. These areas will bring down the overall correlation between the asset classes. In addition, we include more than seven asset classes in our portfolio.

Do take the time an go over Israelsen’s study as it provides additional strength to the asset allocation argument.

Photograph: Hawthorne Bridge and waterfront in Portland, OR

After updating the Mean Variance Optimization (MVO) database for the 14 asset classes used to populate the AA-Mosaic Portfolio, here are the percentages recommended for each asset class.

• Large-Cap Value — 4.9%
• Mid-Cap Value — 7.4%
• Small-Cap Value — 7.0%
• Large-Cap Blend — 3.5%
• Mid-Cap Blend — 6.5%
• Small-Cap Blend — 7.0%
• Large-Cap Growth — 2.1%
• Mid-Cap Growth — 2.1
• Small-Cap Growth — 0.0%
• International — 26.0%
• Emerging Markets — 19.5%
• REITs — 9.1%
• Commodities — 4.9%
• Bonds — 0.0%

Cash is omitted as an asset class.

Note: I used the +/- 30% target limits as constraints for each asset class. For example, the target for Large-Cap Value is 7%. Using a 30% lower limit brings the 7% target to a lower limit of 4.9%. The MVO software is currently recommending one hold only the minimum percentage in the Large-Cap Value asset class.

If any readers have questions about MVO, please ask.

Photograph: Willamette River – Portland, Oregon

Prominent asset allocation critic, William Jahnke, titled his 1997 attack on the Brinson et. al. (BHB) papers, “The Asset Allocation Hoax.” Jahnke’s criticisms of the two papers are many. He argues the authors do not focus on the proper problem, they report the wrong number, cost is not considered, and they give the wrong advice.

To better understand the problem, here is the abstract from the first Brinson, Hood, and Beebower paper, “Determinants of Portfolio Performance.”

“In order to delineate investment responsibility and measure performance contribution, pension plan sponsors and investment managers need a clear and relevant method of attributing returns to those activities that compose the investment management process–investment policy, market timing and security selection. The authors provide a simple framework based on a passive, benchmark portfolio representing the plan’s long-term asset classes, weighted by their long-term allocations. Returns on this “investment policy” portfolio are compared with the actual returns resulting from the combination on investment policy plus market timing (over or underweighting asset classes relative to the plan benchmark) and security selection (active selection within an asset class).

Data from 91 large U. S. pension plans over the 1974-83 period indicate that investment policy dominates investment strategy (market timing and security selection), explaining on average 93.6% per cent of the variation in total plan return. The actual mean average total return on the portfolio over the period was 9.01 per cent, versus 10.11 per cent from the benchmark portfolio. Active management cost the average plan 1.10 per cent per year, although its effects on individual plans varied greatly, adding as much as 3.69 per cent per year. Although investment strategy can result in significant returns these are dwarfed by the return contribution from investment policy — the selection of asset classes and their normal weights.”

Jahnke’s “The Asset Allocation Hoax” is not as easy to find on the Internet as it once was. Here is an article that touches on his criticisms.

http://www.fpanet.org/journal/articles/2000_issues/jfp0100-art13.cfm

The following article on this topic by William Bernstein is well worth a careful look.

http://www.efficientfrontier.com/ef/997/brinson.htm