1 Using the Latest Asset Allocation Techniques to Benefit Your Portfolio Presented at IIR’s Understanding Asset Allocation and Investment Policy Conference Design for Pension Funds June 19, 2000 Michael D. Smith, CFA Research Director Hewitt Investment Group Hewit t
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1 Using the Latest Asset Allocation Techniques to Benefit Your Portfolio Presented at IIR’s Understanding Asset Allocation and Investment Policy Conference.
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Using the Latest Asset Allocation Techniques to Benefit Your Portfolio
Presented at IIR’s Understanding Asset Allocation and Investment Policy Conference Design for Pension Funds
June 19, 2000
Michael D. Smith, CFA
Research Director
Hewitt Investment Group
Hewitt
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Asset Allocation
Asset Allocation Overview• Importance of asset allocation.
• Risk tolerance.
• Impact of investment time horizon on risk tolerance.
• Diversification principles.
• Definition of asset classes.
• Assumption setting for asset classes.
• Limitations of modeling for asset allocation.
• Asset allocation in the context of liabilities.
• Rebalancing policy.
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Importance of Asset Allocation
How Much Does Asset Allocation Explain?• The correct answer is that it depends on how you ask the question.
• Following the Brinson/Beebower studies in 19861 and 19912, most people answer 90%.
• The Brinson study asked what percentage of the variability of return was explained across time by asset allocation.
• The formulation regresses a fund’s monthly return against the monthly return of its policy benchmark.
• There are more interesting questions worth asking!
• Earlier this year Roger Ibbotson3 repeated the Brinson analysis, and asked and answered two new questions.
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Importance of Asset Allocation
Asset Allocation and Return Variability Across Time• Ibbotson’s study examined 94 U.S. balanced mutual funds and 58 pension
funds.
• The answer to the question of variability across time is confirmed by Ibbotson, but the impact of active management and capital market exposure is demonstrated.
95th Percentile NA NA 82% 86%75th Percentile NA NA 94% 96%Median NA NA 100% 99%25th Percentile NA NA 112% 102%5th Percentile NA NA 132% 113%Source: Ibbotson (2000).
Skewed MFdistribution
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Asset Allocation
The “Big Picture”
Capital Market
Expectations
RiskTolerance
Asset
Allocation
Funding
Goal
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Asset Allocation
The “Big Picture”• The goal of the asset allocation process is to select an “optimal” portfolio of
assets given a plan’s risk tolerance and capital market expectations.
• Risk tolerance includes factors such as:— Time horizon;— Demographics;— Plan design;— Funded level; and— Ancillary goals.
• Typically, assets are modeled with a “mean/variance” optimizer, and the results are integrated with liability modeling.
• Goal analysis determines the probability of achieving various funding targets.
• The most important result for asset allocation is the target level of equity exposure.
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Asset Allocation
Risk Tolerance Public Pensions• There are three major determinants of risk tolerance for a public plan:
• Business and financial position.— Ability to get additional contributions if investments perform poorly in
the short-term;
• Workforce demographic characteristics; and — Average age and years of experience, active/inactive ratio, retiree
liability to plan assets (i.e., duration of liabilities).
Note: The composition of the “No Rebalancing” portfolio is 57.1% stocks and 42.9% bonds at the end of year 1.
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Rebalancing Overview
Why Rebalance?—Investment Policy• During the last five years, rebalancing has
“cost” plan sponsors relative to a “Let Run” policy.
• The strong stock market increased the average equity exposure of a 65%/35% portfolio to 74% during the five years ended 1999.
• The time based and exposure based rebalancing rules resulted in similar results during the last five years.
• The “Let Run” portfolio outperformed both rebalancing rules by 1.6% per year.
• “Let Run” was riskier, but can you “eat” risk adjusted return?
• Why rebalance?
Value of 65%/35% Portfolio
100
150
200
250
300
1995 1996 1997 1998 1999
Wea
lth I
ndex
"Let Run"
Quarterly Rebalancing
5% Proportional Rebalancing
1995 to 1999 Return Risk_Let Run (65%/35%) 22.8% 11.0%Quarterly Rebal. 21.2% 9.4%5% Proportional Rebal. 21.2% 9.3%
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Rebalancing Overview
Why Rebalance?—Investment Policy• You can “eat” risk-adjusted return when it
comes to rebalancing!• Allowing the equity exposure of the
65%/35% portfolio to increase over time results in a portfolio that averages 74% equity.
• Comparing the “Let Run” with rebalanced portfolios is like comparing portfolios with different equity allocations—and contains the same “information.”
• Rather than letting equity exposure “creep,” it is preferable to adopt a higher equity exposure, and rebalance.
Value of 74%/26% Portfolio
100
150
200
250
300
1995 1996 1997 1998 1999
Wea
lth I
ndex
Let RunQuarterly5% Proportional
1995 to 1999 Return Risk__Let Run (65%/35%) 22.8% 11.0%Quarterly Rebal. 23.1% 10.7%5% Proportional Rebal. 23.2% 10.9%
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Asset Allocation
Diversification — The Role of Rebalancing• Most mean/variance models assume that assets are rebalanced back to target
levels at some point.
• Without rebalancing, diversification is incomplete.
• Without rebalancing, the addition of non-correlated assets will reduce volatility, but will not enhance returns.
• A clear policy avoids costly ad-hoc revisions.
• If you do not rebalance, the market will do it for you.
• Rebalancing is a vital part of investment policy.
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Asset Allocation
References
• 1Brinson, Gary P., L Randolph Hood, and Gilbert L. Beebower. 1986. “Determinants of Portfolio Performance.” Financial Analysts Journal, vol. 42, no. 4 (July/August): 39-48.
• 2Brinson, Gary P., L Brian D. Singer, and Gilbert L. Beebower. 1991. “Determinants of Portfolio Performance II: An Update.” Financial Analysts Journal, vol. 47, no. 3 (May/June): 40-48.
• 3Ibbotson, Rodger, Paul D. Kaplan. 2000. “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal, vol. 56, no. 1 (January/February): 26-33.