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The Asset Allocation Decision for Physician Investors

A Historical Perspective for all Lay and Medical Professionals

By Manning & Napier, Inc.

http://www.manning-napier.com/

Introduction

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To a large extent, your investment objectives are driven by your investment time horizon and the needs for cash that may arise from now until then.  Once these objectives have been set, you must decide how to allocate assets in pursuit of your goals.  Establishing the appropriate asset allocation for your portfolio is widely considered the most important factor in determining whether or not you meet your investment objectives.  In fact, academic studies have determined that more than 90% of a portfolio’s return can be attributed to the asset allocation decision.  The following will provide a historical perspective on the risks which need to be balanced when making the asset allocation decision, and the resulting implications regarding the way this important decision is made by investors today.

The Balance between Growth and Preservation of Capital

The asset allocation decision (i.e., identifying an appropriate mix between different types of investments, such as stocks, bonds and cash) is the primary tool available to manage risk for your portfolio.  The goal of any asset allocation should be to provide a level of diversification for the portfolio, while also balancing the goals of growth and preservation of capital required to meet your objectives.

How do investment professionals make asset allocation decisions?  One way is a passive approach, in which a set mix of stocks, bonds and cash is maintained based on a historical risk/return tradeoff.  The alternative is an active approach, in which the expected tradeoff between risk and return for the asset classes is based upon the current market and economic environment.

Can any single mix of stocks, bonds and cash achieve your needs in every market environment that may arise over your investment time frame?  If such a mix exists, then it is reasonable for you to maintain that particular passive asset allocation.  On the other hand, if no single mix exists that will certainly meet your objectives over your time frame, and then some judgment must be made regarding the best mix for you on a forward-looking basis.  This case implies that some form of active decision making is required when determining your portfolio’s asset allocation.  To answer this question, let’s consider the historical tradeoff between the pursuit of growth and the need to preserve capital over various investment time frames.

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The Need for Growth

Our first conclusion is that you have to be willing to commit a majority of your assets to stocks to pursue capital growth, but even an equity-oriented portfolio is not guaranteed to meet your growth goals over a long-term time period.  To provide some historical perspective using Ibbotson data, a mix of 50% stocks and 50% bonds provided an 8.9% annualized return from 1926-1998, but failed to surpass what many consider to be a modest return of 8.0% in approximately 49% of the rolling ten and twenty year periods over this time.  In fact, a portfolio of 100% stocks provided an 11.2% annualized return, but failed to surpass 8.0% in almost 1 of every 3 ten-year periods and more than 1 of every 4 twenty-year periods.

This data also reflects the difficulty through history of consistently achieving an 8.0% rate even with an aggressive mix of stocks and bonds.  In this time of high flying stock markets, it is important to keep in mind that taking more risk is no guarantee of higher returns.  However, what is clear from this data is the importance of allowing a manager the flexibility to achieve meaningful exposure to stocks in attractive market environments to pursue the goal of long-term capital growth.

The Need for Capital Preservation

Of course, there is a clear risk of long-term declines in an equity-oriented investment approach, especially for a portfolio dealing with interim cash needs (e.g., a defined benefit plan with ongoing benefit payments, a defined contribution plan with participants having different dates until retirement, or an endowment with ongoing withdrawal needs).  An illustration of the sustained losses that may result from heavy allocations to stocks is the fact that 1 of every 4 one year periods and 1 of every 10 five-year periods resulted in a loss for a portfolio of 100% stocks.  Even the 50% stock and 50% bond portfolio has seen losses in almost 1 of every 5 one-year periods and more than 1 of every 25 five-year periods over the past 73 years of available data.  Thus, it is clear that no single mix of investments is likely to meet all of the needs for a portfolio in every market environment.

The Need for Active Management of Risk

The analysis to this point has discussed the need to balance long-term growth and preservation of capital, and it has summarized the tradeoff between these conflicting goals.  There remains, however, an important issue regarding the appropriate stock exposure for you in the current environment.  Even though returns over the long-term may have been strong for an all-stock portfolio, your returns will be very much dependent on the market conditions at the start of the investment period.

To set up this discussion, consider the risk of failing to achieve a target return of 5%, 8% or 10% in the S&P 500 over the last 44 years.

FAILURE RATES OF TARGET RETURNS IN STOCKS [1955-1998]

 

   1 Year  3 Years  5 Years  10 Years
 % Periods with Less Than a 5% Return:   32%   15%   17%   13%
 % Periods with Less Than an 8% Return   38%   29%   27%   32%
 % Periods with Less Than a 10% Return   41%   41%   41%   44%

 

Taking the risk of failing to achieve your return goals one step further, does this risk increase with an expensive stock market?  Looking at several different stock valuation measures, the U.S. stock market is currently at historically extreme levels.  As an example, the S&P Industrials price-to-sales ratio was 2.0 at the end of 1998.  High valuation measures are often associated with periods of high volatility in stocks, and a price-to-sales ratio greater than 1.0 (i.e., ½ of current level) has historically been considered high.

FAILURE OF STOCKS TO MEET GOALS WHEN S&P INDUSTRIALS PRICE-TO-SALES RATIO IS GREATER THAN 1.0 [1955-1998]

 

   1 Year  3 Years  5 Years  10 Years
 % Periods with Less Than a 5% Return:   42%   26%   24%   45%
 % Periods with Less Than an 8% Return   47%   55%   55%   79%
 % Periods with Less Than a 10% Return   49%   71%   71%   97%

 

Understanding the Data

The data in the table above indicates that high market valuations significantly increase the risk of failing to achieve even moderate return goals.  In all, there were 50 quarters from 1955 to 1998 in which the S&P Industrials price-to-sales ratio was over the 1.0.  During these periods, strong returns were possible, but less likely to be sustained than when there are less optimistic valuations in the market.  While this does not mean that a major correction or bear market will necessarily occur, the risk of failing to meet your goals is clearly higher than average based upon this data.  Because the market is a discounting mechanism, the positive economic environment we see today may become over discounted, resulting in moderate returns until fundamentals catch up with the optimism.

Assessment

Clearly, history tells us that no single mix of assets may provide both long-term capital growth and stability of market values in all market and economic conditions.  Far too often, investment professionals take a passive approach to asset allocation, relying on past average returns and correlations to determine asset allocation without a full understanding of the long periods of time in history over which there are significant deviations from long-term averages. This data confirms that a more active approach to asset allocation based on the risk faced in today’s market and economic environment is key to lowering the risk to your portfolio failing to meet its investment objectives.

Conclusion

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Managing for Endowment Portfolio Alpha

Understanding Non-Systematic Return on Investment

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DEM 2013

[By Dr. David Edward Marcinko MBA]

According to Wayne Firebaugh CPA, CFP®, CMP™ alpha measures non-systematic return on investment [ROI], or the return that cannot be attributed to the market.

It shows the difference between a fund’s actual return and its expected performance given the level of systematic (or market) risk (as measured by beta).

Example

For example, a fund with a beta of 1.2 in a market that returns 10% would be expected to earn 12%. If, in fact, the fund earns a return of 14%, it then has an alpha of 2 which would suggest that the manager has added value. Conversely, a return below that expected given the fund’s beta would suggest that the manager diminished value.

In a truly efficient market, no manager should be able to consistently generate positive alpha. In such a market, the endowment manager would likely employ a passive strategy that seeks to replicate index returns. Although there is substantial evidence of efficient domestic markets, there is also evidence to suggest that certain managers do repeat their positive alpha performance.

In fact, a 2002 study by Roger Ibbotson and Amita Patel found that “the phenomenon of persistence does exist in domestic equity funds.” The same study suggested that 65% of mutual funds with the highest style-adjusted alpha repeated with positive alpha performances in the following year.

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More Research

Additional research suggests that active management can add value and achieve positive alpha in concentrated portfolios.

A pre 2008 crash study of actively managed mutual funds found that “on average, higher industry concentration improves the performance of the funds. The most concentrated funds generate, after adjusting for risk … the highest performance. They yield an average abnormal return [alpha] of 2.56% per year before deducting expenses and 1.12% per year after deducting expenses.”

FutureMetrics

FutureMetrics, a pension plan consulting firm, calculated that in 2006 the median pension fund achieved record alpha of 3.7% compared to a 60/40 benchmark portfolio, the best since the firm began calculating return data in 1988. Over longer periods of time, an endowment manager’s ability to achieve positive alpha for their entire portfolio is more hotly debated.  Dimensional Fund Advisors, a mutual fund firm specializing in a unique form of passive management, compiled FutureMetrics data on 192 pension funds for the period of 1988 through 2005.

Their research showed that over this period of time approximately 75% of the pension funds underperformed the 60/40 benchmark. The end result is that many endowments will use a combination of active and passive management approaches with respect to some portion of the domestic equity segment of their allocation.

Assessment

One approach is known as the “core and satellite” method in which a “core” investment into a passive index is used to capture the broader market’s performance while concentrated satellite positions are taken in an attempt to “capture” alpha. Since other asset classes such as private equity, foreign equity, and real assets are often viewed to be less efficient, the endowment manager will typically use active management to obtain positive alpha from these segments.

Notes:

  • Ibbotson, R.G. and Patel, A.K. Do Winners Repeat with Style? Summary of Findings – Ibbotson & Associates, Chicago (February 2002).
  • Kacperczyk, M.T., Sialm, C., and Lu Zheng. On Industry Concentration of Actively Managed Equity Mutual Funds. University of Michigan Business School. (November 2002).
  • 2007 Annual US Corporate Pension Plan Best and Worst Investment Performance Report.  FutureMetrics, April 20, 2007.

Conclusion

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