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A successful asset allocation strategy is one that clients can live with regardless of what the market is doing.
Financial planners often argue about when asset allocation crosses the line and becomes closet market-timing. It's not always easy to pinpoint this metamorphosis. Everyone agrees that the best asset allocation strategy is the one that simultaneously minimizes risk and maximizes return within the parameters of a client's investment objectives. But just how to accomplish such a task is a source of considerable controversy.
One school of thought maintains that market movements offer opportunity and that one should take advantage of market shifts by adjusting asset allocations accordingly, even though it is impossible to divine the precise future direction of any market. Another holds that one cannot predict market movements and therefore cannot beat the market. Some planners determine specific allocation percentages, which they apply to most of their clients' portfolios, while others approach their clients with only the broadest notions of allocation. But planners do concur that whatever the approach, client communication is paramount. Listening and responding appropriately to clients' needs is at the heart of any successful asset allocation strategy.
Cynthia Elinoff of C.S. Elinoff Financial Services in Vestal, N.Y., wants her clients to be comfortable with their portfolios regardless of short-term market fluctuations. "When I think about asset allocation," she explains, "I think about it on two levels." According to Elinoff, the first level concerns the client's needs, goals and risk tolerance, and the second level addresses diversification. She looks to her clients to guide the allocation strategy. "If they are very edgy about the market, you may want to have a more conservative diversification," she says, "whereas if they are more comfortable with the volatility of the marketplace, you may go more heavily into it."
Prior to meeting with a client and determining his or her profile, Elinoff does not have very specific allocation percentages in mind. She knows that she will encourage diversification, but the details will depend heavily on the client's characteristics.
Communication with clients is key to Elinoff's role as planner. "It's more a role of listening to them, listening to their concerns and trying to educate them as to what will work and what won't work-what will get them to where they want to be," she says.
On the other hand, some financial planners do have very specific asset allocation percentages that they apply to most clients. Mark Balasa, president of Balasa & Hoffman Inc. in Schaumburg, Ill., is one such planner. His allocations are driven in part by his views on the markets. Balasa's view of the stock market's present level of valuation is dark. "We think there's either going to be an extended period of low, single-digit returns or there are going to be some negatives coming here," he says.
Given his market outlook, Balasa is overweighting value stocks and underweighting growth stocks in both the large- and small-cap U.S. categories. "The market pushes us to be a little bit more conservative than we might otherwise be," he says. Balasa allocates 45% of his clients' stock portfolios to large-cap U.S., 25% to small-cap U.S. and 30% to international. He says this breakdown represents an underweighting of U.S. large-cap stocks and an overweighting of international relative to a year ago.
Furthermore, Balasa's bleak market outlook has prompted him to take extra precautionary measures for his retired clients, increasing the cash component of their portfolios to 12 to 18 months' worth of living expenses, an increase of three to six months' worth of emergency funds. This will provide them additional cushion for the hard times he expects to come.
For the bond component of his allocation, he prefers short-term, high-grade bonds. "We're sticking with shorter maturities because of what's going on in the interest-rate world," he says. He believes that rates are more likely to go up than down in the current environment.
Balasa describes a moderately conservative, long-term allocation as 55% stock and 45% bonds, with 6% to 8% cash included in the bond portion. For more aggressive clients, he would go as high as 100% in equities.
In the current environment, market-neutral funds also appeal to Balasa, which he considers equivalent to bonds. He says a market-neutral fund invests in undervalued stocks and simultaneously shorts overvalued stocks in the same industries with similar capitalizations to the undervalued stocks. The fund then invests the proceeds of the short sales in T-bills. The intention, Balasa says, is to achieve an enhanced yield over the T-bill rate. "It's not exactly a stock; it's not exactly a bond," he says. Market-neutral funds account for 5% to 10% of his clients' portfolios.
Charlie Haines, president of Haines Financial Advisors in Birmingham, Ala., also takes a very quantitative approach to asset allocation. But he describes his method as quasi-art and quasi-science. Haines relies heavily on a computerized portfolio optimization model which, given inputs of expected returns, standard deviations, correlation coefficients and transaction charges, is designed to produce the best asset allocation. "It tells you what percentage, down to practically a thousandth of a percent if you want, of the portfolio should be in a particular asset class," he says.
But the inputs to his model are future estimates, based on past experiences. "So, we're hoping that the standard deviations and correlation coefficients have some relationship to reality in the future," he acknowledges.
Once Haines sets the allocation, he may change it every six months or so based on market conditions, but not more frequently than that. "You eyeball it and go with experience and instincts," he says. "I mean, there's still plenty of art. And anybody who says that there isn't, there is a state mental hospital in Alabama that I'm sure has a bed for that person."
Given the degree to which the asset allocation process is art rather than science, Haines questions the extent to which he and his financial planning colleagues are worth their fees. But he believes the answer to that question, at least for his firm, is yes.
Even after fees, Haines says, his portfolio optimization techniques have historically generated superior risk-adjusted returns, beating the indexes he's chosen as benchmarks, with one notable exception: the Standard & Poor's 500 has outperformed his clients' portfolios over the past three years. Then again, there aren't many portfolios that have surpassed the S&P 500 since January 1995.
But there are those who do not believe that planners are capable of consistently generating better-than-market returns for their clients. Meir Statman, professor of finance at Santa Clara University in Santa Clara, Calif., and chief investment officer at Reinhardt Werba Bowen in San Jose, says, "Financial advisers who pride themselves on being able to beat the market are really lying to themselves and lying to their clients."
Statman describes two kinds of asset allocation, strategic and practical. Strategic asset allocation deals with the client's needs and long-term goals, risk profile and portfolio diversification. In his view, the purpose of strategic asset allocation is to reduce risk by diversifying among the major asset classes. And the strategic allocation of a client's portfolio should change only as the client's profile changes (for example, as the client ages).
Statman describes practical asset allocation as dealing with the underweighting and overweighting of various asset classes in anticipation of their relative performances, given market conditions. "The evidence of the ability to do practical asset allocation, surely at the level of the adviser," says Statman, "is such that it should convince anyone in his right mind that this is a disaster."
He sees the role of the financial planner not as market forecaster, but as parent or teacher, with the responsibility to explain to clients the reasoning behind an asset allocation strategy and why diversification makes sense. "What investors want is not asset allocation, they don't want diversification, they don't want a reduction in risk," Statman says. "What they really want is to have been in the best performing asset class." That's certainly been true in the '90s.
To fight against this visceral hindsight bias, Statman recommends taking clients back in time to when the plan was set, recalling exactly what the client wanted to accomplish and examining what was really known at the time. Statman suggests that planners should expect clients to second-guess their allocation strategies with the benefit of hindsight, years after the plans were put in place. "I think that this in fact is going to lead many [planners], for example, to have less foreign stocks than is wise for diversification purposes," Statman says, "because they know people are going to be more upset if the loss comes from abroad than if it comes from the U.S."
Peter Brown, partner at Evensky, Brown, Katz & Levitt in Coral Gables, Fla., has recently decreased the foreign exposure of his clients' portfolios, eliminating the entire international bond portion. With the advent of the euro, Brown is less certain of the diversification benefits of being invested in Europe. "You're going from a bunch of countries basically down to one currency," he says. "And better we should err on the side of conservatism." Brown has also been moving toward passive investing and index allocation. Like Statman, he does not believe that beating the market is a realistic goal. "We have less and less faith in active managers," he admits.
However, index funds don't offer enough allocation control for Scott Leonard, president of Leonard Wealth Management, Inc. in Santa Monica, Calif., so he uses mutual funds with very specifically defined mandates. "I feel that I am really the manager of the managers," he says. "It's my job to design the portfolio. It's their job to buy the stocks within the asset class that I'm using them for."
Leonard creates what he calls the super-portfolio, an all-equity portfolio with what he believes to be optimal diversification characteristics. "There is no magic for this," he says. "It's really as much guesswork as it is an optimizer or anything else."
The asset allocation defined by his super-portfolio is what he then uses for the equity portion of all of his clients' portfolios, with perhaps some adjustments to meet specific client needs. The fundamental difference among most of his clients' portfolios, then, is their percentage of bond holdings, which depends on their risk profiles.
The bonds he prefers are short-term and high-quality. This is not because of market conditions, but rather because he believes that stocks generally offer a higher return for incremental risk than bonds.
Leonard is not a market timer. Even though he is wary about the lofty heights of the current U.S. market, he says the allocations he makes for a given portfolio today are essentially the same as they would have been three years ago. This may not be the strategy that a computerized portfolio optimizer would recommend, but Leonard has grown disillusioned with these programs. "What we've really learned is those things are kind of mistake maximizers," he says.
Because of the guesswork required for the inputs and the programs' propensity to gravitate toward the highest-returning asset class, Leonard says, optimizers often generate a return estimate that is too high and will attract a disproportionate percentage of assets in the wrong investments.
So, what are advisers telling clients if they have no idea of what the future will hold? "The bad news is that I have no idea where the market is going next week, next month, next year, and quite frankly I don't think anybody does," Leonard says. "The good news is [that by] setting up really well-diversified, globally diversified portfolios, you don't have to know. You're going to be successful regardless."
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