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7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 5th Deadly Sin – Misapplied Asset Allocation

June 09
00:03 2015

(The following is the first of a special five part series meant to be shared by professionals and non-professionals alike. This particular series covers
only one of the 7 Deadly Sins Every ERISA Fiduciary Must Avoid.)

959820_18489691_bling_stock_xchng_royalty_free_225Covetousness (in the ecclesiastical world) – In order to carry on whatever good work we choose to do, we will require some material goods. The weather is not always perfect, not even in a tropical paradise. We need, at the very least, a roof on our head, some means of storing and cooking our food, some means to provide a means to procure that food and, for at least some of us, good in-door plumbing. On the flip side, while requiring some material goods for sustenance, we should not excessively crave superficial possessions.

Covetousness (in the investment world) – Asset Allocation (the wanton accumulation of material goods for the sake of owning these goods, even if their possession offers no benefit to one’s goals.)

By the mid 1960’s, a small group of finance professors had developed a mathematically elegant theory to explain the performance of investment portfolios. Made all the more powerful by using the simple common sense notion that the greater the risk one takes, the greater the return one obtains, the creators of this Modern Portfolio Theory eventually received the Nobel Prize.

Modern Portfolio Theory (“MPT”) seemed to explain all the necessary questions regarding the accepted relationship between risk and return. It remained a theory, however, until the explosion of index funds in the mid 1980’s. With these investment vehicles, the fundamental data behind MPT – broad market indices – moved from the chalkboard to the trading floor. It was through this that Asset Allocation, the prodigal son of MPT, graduated from academic theory to practical reality. With Asset Allocation, the financial services industry had its Holy Grail – the Lorelei Song that would continually and reliable lure investors to their shores.

Before we begin, given some of the feedback we’ve already received on this subject, we offer this warning: What you are about to read may shock you and make you uncomfortable. We ask readers to keep an open mind when reading this particular series. It reveals facts that are often omitted from the standard investment education presentation – whether that presentation be for the investing public or investing professionals. As such, despite the strong academic roots of the sources disclosed in these articles, some readers may find these facts contrary to their practiced world view. As the truths we are about to unveil may shock some, we can only ask these reader to wait until this entire series of five articles is published before rendering judgment or commenting.

The Allure of Asset Allocation
Asset Allocation represents the fruit of vine for most (but – and this is an important “but” – not all) financial service providers. As the number of financial planners and broker-advisors exploded in the 1990s, the traditional securities analysts left behind, content to run their stock selection screen bathed in the warm greenish glow of the cathode ray tubes within their comfortable cubicles. This is not their story. This is the story of the masses that overtook them in the public understand of what an “investment adviser” was.

For those advising investment without the desire to select individual securities, asset allocation filled the need for an effective marketing/service concept. It was easy to explain on the part of the professional and relatively easy to understand on the part of the retail investor. Nowhere is this better reflected than in the ubiquitous pie chart, the lasting legacy of Asset Allocation. It’s usually blazing colors beckon investors. The pie chart neatly compartmentalizes an otherwise confusing world, allowing all to participate with apparent understanding. And with this comfort, investors more willingly and confidently have assign their treasured assets to those wizards of Wall Street who dabble in the beautiful, yet esoteric, mathematics behind the curtain of the pie chart.

The power of presentation trumped the nerdiness of the securities analyst. The industry gathered assets not by the record of their stock pickers (after all, past performance can never guarantee future results) nor by their strict adherence to an investment discipline. No, assets gushed into the industry’s waiting arms through the “non-denominational” marketing of Asset Allocation.

Asset Allocation: The Perception (or Misperception?)
What was this wonderful “promise” of Asset Allocation that caused the phenomenon to go viral almost from the moment that HP plotter (that was the only way to escape black-and-white back then) inked the first multicolored presentation? “The ‘promise’ of Asset Allocation,” says Froilan Rellora, Chief Investment Officer at Catalina Asset Management in Mesa, Arizona,  “is to balance risk and reward by distributing portfolio assets according to an individual’s goals, risk tolerance, and investment time horizon. Typically, portfolio assets are divided among equities, fixed income, and cash since they each perform differently during various market conditions.”

Michael Prus, President of Scale Investment Group in Detroit, Michigan, puts it more bluntly. He says, “The promise of Asset Allocation is (or at least should be) diversification and protection against any one security or asset class blowing up a portfolio.”

The desire to not “blow up” one’s portfolio means only one thing: avoiding losses. “Asset Allocation in theory is the promise or expectation that if we diversify, we will be protected from major loss in our investments,” says Alex Sylvester, Senior Account Executive at Assured Neace Lukens in Indianapolis, Indiana.

These views reflect the common perception of what Asset Allocation is. Those trained in the original intent of Asset Allocation see it quite differently. “I don’t know that there is any ‘promise’ in asset allocation. It is one step in the process of constructing a portfolio to meet the unique needs of clients,” says Robert R. Johnson, President and CEO, The American College of Financial Services located in Bryn Mawr, Pennsylvania. “Asset Allocation,” he continues, agreeing with Rellora’s basic definition, “is part of an investment strategy that attempts to prescribe an appropriate mix of broad asset classes consistent with a client’s goals and objectives and risk tolerance. Older, risk averse individuals will have a more conservative mix of stocks and bonds than younger, less risk averse individuals. It prescribes the mix of broad asset classes, leaving security selection to be separately considered.”

Despite Johnson’s textbook response, many continue to see Asset Allocation as primarily a way to reduce losses. Mike O’Donnell, Wealth Manager at The O’Donnell Group in Chico, California, says, “Asset Allocation helps minimize the risk of big losses, which are what can be the most harmful. If your portfolio loses 20%, you need 25% to be back to even. If it loses 50% then you need 100% to be back to even. Not only spreading amongst stock asset classes will limit volatility, but also asset classes like bonds and cash. Bringing in the different asset classes we can actually engineer certain volatility constraints, and return expectations over time.”

“The concept of Asset Allocation is to reduce risk and volatility of one’s portfolio and that is exactly what it does,” says Jeffrey A Bogart, a Registered Investment Advisor with Sila Wealth Advisory in Mayfield Heights, Ohio. “On the up side Asset Allocation captures the returns of all the asset classes one invests in. The timing of any asset class’ return is random when it happens and you must be in the asset class to capture the return. One cannot do so looking backward and attempting to chase the good returns of a previous year.”

Murray Carter, CFP, Executive VP – Wealth Management, CSG Capital Partners of Janney Montgomery Scott, says the benefit of Asset Allocation is that “over market cycles a prudently diversified portfolio will provide sufficient returns at reduced volatility; thus, enabling an investor to weather times of turbulence and not make knee jerk portfolio adjustments.”

In describing Asset Allocation, it’s all too common the Fourth Deadly Sin begins to rear its ugly head (see “7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 4th Deadly Sin – Overdiversification,” FiduciaryNews.com, October 25, 2015). Joe Gordon, a partner at Gordon Asset Management, LLC in Durham, North Carolina, says Asset Allocation means “that diversification can reduce risk long term especially with the inclusion lower correlated asset classes.” The term “diversification” may not quite share the same circumstances of the series devoted to the Fourth Deadly Sin (which focused on stocks, not asset classes), but, all the same, there’s no harm in looking at it as a warning signal to trigger greater due diligence, especially on the part of the 401k plan fiduciary. Indeed, as we shall see in the next article in this series, it’s not too much of a stretch to move from stocks to assets classes, given how Asset Allocation evolved.

While there are times when investors do not apply Asset Allocation properly, the correct application evokes high expectations. Sylvester sees “Asset Allocation as a great concept when implemented correctly. Too often investors are not properly spread amongst uncorrelated categories thus giving them mistaken protection. When asset allocation is executed the right way, investors should feel confident that they are mitigating the ‘catastrophic loss.’”

But how realistic is the mitigation of a “catastrophic loss”?

What Happened in 2002 and 2008/09?
Twice in the first decade of the new millennium we saw years when Asset Allocation appeared to fail. By 2009, the popular press began running stories about the failure of Asset Allocation. In “Failure of a Fail-Safe Strategy Sends Investors Scrambling,” (Wall Street Journal, July 10, 2009), we find the quote “Asset allocation, a bedrock of investing for decades, appeared to fail miserably in 2008. The conviction shared by most investors – that they should spread their money across myriad asset classes to minimize losses – was shaken as nearly all markets tumbled in unison.” The piece shows how “Asset Allocation” mutual funds (i.e., Target Date Funds) fell, on average, in excess of 30% compared to the S&P 500’s fall of 37% that year. Indeed, that same article says, “…a number of influential investors and analysts, from managers of massive funds such as Pacific Investment Management Co., or Pimco, to those at small school endowments, argue that asset-allocation strategies are fundamentally flawed. This wasn’t a one-off failure, they say, but one that’s been long in the making.”

Were 2002 (more subtly) and 2008 (more dramatically) a failure of Asset Allocation for investors, or were they a failure of investors to properly allocation their assets? “In my experience many of the investors that were hit the hardest in 2002 and 2008 were improperly diversified,” says Sylvester says. “They felt that selecting various equity funds would protect them from catastrophic loss. When in reality, they were selecting correlated assets that gave them a false sense of protection.”

Now more than a half decade after the 2008/09 market crash, we see reluctance to throw in the towel on Asset Allocation. “I don’t think it’s a case of Asset Allocation not working,” says Prus. It’s a case of expectations of what asset allocation can do being exaggerated. When benefits are over-promised, it is easy for the strategy to under-deliver. Asset Allocation is not a panacea and does not prevent volatility or even losses. With that said, 2008/2009 was a unique time given the source of the recession was deeply rooted in the fixed income markets.”

David M. Williams, Director of Planning Services at Wealth Strategies Group in Cordova, Tennessee, doesn’t believe people were hurt by Asset Allocation. He says “they were hurt by the asset class universe they considered. Traditional securities (stocks, bonds, and their immediate derivatives) tend to vary in performance when there are upward environmental forces, but they tend to correlate when there are downward environmental forces. We say that a rising tide raises all ships, but some ships stand taller in the water, so they reach higher points. However, a toilet flushes all. Correlation of asset classes change frequently and greatly as market environmental conditions change.”

Johnson agrees. Hesays, “I don’t think asset allocation hurt investors in the two periods cited. If they expected it to protect them against down markets, then they didn’t understand what it is meant to do. While it certainly didn’t protect investors against adverse markets, that isn’t the goal of asset allocation. If investors are relying on asset allocation to protect themselves against market corrections, they are mistaken. Asset allocation is the broad structuring of selection of assets that is unique to an individual’s personal circumstances. Risk averse individuals will have a high percentage of assets in short term, low risk fixed income investments, while younger less risk averse individuals will have a larger percentage of assets in equity securities.”

Truth be told, in both years, despite the preponderance of “failed” Asset Allocation portfolios, there were asset classes that managed positive returns. Carter says, “While I agree that in the market decline of 2008/09 that diversification did little to cushion the decline. I disagree regarding 2002, where fixed income and international would have cushioned much of the pain. In 2002 the average investor believed that diversification was owning technology stocks. This market decline was not one where diversification failed. However, this was where investors failed to be diversified. Now fast forward to 2008/09 where investors were much better allocated after learning the lessons of 2002. Unfortunately, this time, diversification provided little support. Now one can argue that even a modestly smaller net decline would still be better than the full decline of a concentrated portfolio of stocks. Hopefully, any diversity gave the investor even a moderate amount of confidence to ride out the market decline and not panic to a cash position subsequently missing the markets recovery.”

If 2002 and 2008/09 do not represent a failure of Asset Allocation, they may hint at its Achilles’ Heel. David Larrabee, Director, CFA Institute, Charlottesville, Virginia, says, “The ‘failure’ of Asset Allocation in 2002 and the 2008/09 period may be best explained by the fact that in times of extreme market shocks and crises, correlations between asset classes tend to increase. Over longer time periods, I think the benefits of diversifying across asset classes remain valid. (I’d also point out that US the 10-Year Treasury Bond performed well in both 2002 and 2008, in contrast to equity returns in those years.)”

Yale Emeritus Professor Roger Ibbotson, Chairman and CIO at Zebra Capital and Founder of Ibbotson Association agrees with Larrabee. He says, “In 2008/09, high grade bonds did well as yields fell.” Ibbotson also provides important instruction to those who might be fooled into thinking Asset Allocation can deliver more than it’s intended during severe market downturns. “In general,” he says, “as correlations converge, Asset Allocation is less likely to be successful as it’s harder to find investments that do well. Asset Allocation is not going to be as effective in a crisis, it is not going to do the complete job, but it will do part of the job. In the short term it may not deliver when it’s needed the most, but over the long term, Asset Allocation, with the help of time diversification, certainly helps.”

Mark Lund, author of The Effective Investor and located in Draper, Utah, provides both an apt summary to this portion of our series as well as some practical guidance when he says, “Asset allocation does not prevent a portfolio from going down in value. A truly diversified portfolio always has something that does well and something that is not doing well, this allows for a rebalance on the portfolio. A rebalance allows the manager to sell what is doing well during a market crash or correction and buy more of what is down.”

Just how did we get in this fine mess we call Asset Allocation. In Part II we’ll briefly describe the history of Asset Allocation before exposing the most the biggest mistake nearly all professionals make regarding Asset Allocation.

Part I: 7 Deadly Sins Every ERISA Fiduciary Must Avoid: The 5th Deadly Sin – Asset Allocation
Part II: How’d an Innocent Fiduciary Like You End Up Asset Allocating?
Part III: Asset Allocation’s Greatest Failure: Short-Term Investing
Part IV: Why Asset Allocation Doesn’t Matter In The Long Run
Part V: The Hows, Whys, and Right and Wrong Way to Use Asset Allocation

Are you interested in discovering more about issues confronting 401k fiduciaries? If you buy Mr. Carosa’s book 401(k) Fiduciary Solutions, you’ll have at your fingertips a valuable reference covering the wide spectrum of How-To’s (including information on the new wave of plan designs) every 401k plan sponsor and service provider wants and needs to know. Alternatively, would you like to help plan participants create better savings strategies? You can buy Mr. Carosa’s latest book Hey! What’s My Number? How to Improve the Odds You Will Retire in Comfort right now at your favorite on-line or neighborhood book store.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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