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How’d an Innocent Fiduciary Like You End Up Asset Allocating?

June 10
00:49 2015

(The following is the second 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.)

The modern concept of fiduciary investing has evolved from common trust law over several centuries. In the nineteenth century, trustees managed investments in terms of their ability to generate income. These were considered “prudent” 1369688_27589513_venice_alley_stock_xchng_royalty_free_300investments. Moreso, individuals states often proscribed the types of investments trustees were legally permitted to make.

The Primordial Era
As we learned earlier, (see “How the Fiduciary Discovered What’s Wrong With Emphasizing Income,”, May 25, 2011), the bell weather event in America’s first century of trust law was the 1830 case of Harvard College v. Amory. Poor Francis Amory. He was the sole surviving trustee of a trust created upon the death of John McLean. McLean’s trust allowed the trustees to invest in all sorts of odd things, including stocks. Unfortunately, the stocks went bankrupt and the trust became valueless. Harvard College and Massachusetts hospital sued Amory for failure to invest prudently.

In assessing the case, the court determined, “It will not do to reject those stocks as unsafe, which are in the management of directors, whose well or ill directed measures may involve a total loss. Do what you will, the capital is at hazard.”1 In exonerating Amory, its conclusion became the beacon of trust law henceforth: “All that can be required of a trustee is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.”2 With that, the Prudent Man Rule was born.

As the implications of the Prudent Man Rule took hold, more and more trustees considered stocks as a viable investment option. With the possibility of garnering tremendous returns, it became standard fiduciary protocol to at least conduct a due diligence review on equities. Mind you, the bias was still towards bonds, and, for the most part, the most favored type of equity usually had a significant dividend attached to it. Still, it took nearly a century, but by World War II, nearly every state now specifically permitted investments in stocks.

The bread and butter of the Prudent Man Era remained with us well into the 1960s (among institutional investors) and as deep as the 1990s (among retail-oriented professionals and investors). You might recognize these as the traditional assets classes of stocks, bonds, and cash, as well as the traditional investment goals (which matched their respective assets classes) of growth, income, and safety. Post World War II, and its culture of operational logistics, soon changed the way the industry looked at portfolio management.

The Modern Era
For more than a century, trust law, trust management, and trust philosophy all emphasized “safety” over “growth,” all couched within the leitmotif of “income.” This all changed during the era of the ascendency of Modern Portfolio Theory (MPT).  We saw a shift from the traditional investment goals to the modern investment goals (see “401k Plan Sponsors: Is Your Investment Policy Statement Still Using Outdated Language?, May 17, 2011). At the same time, we witnessed a momentous rejection of “income” as the underlying premise of portfolio management to “total return.” While MPT initially focused on individual securities, researchers soon realized one could readily substitute asset classes for individual securities. Furthermore, there was a broader mix of asset classes. These asset classes now included “stocks, bonds, cash, real estate, foreign securities, derivative securities, gold and possibly others to achieve the best portfolio given the investor’s objectives and constraints.”3

For ERISA fiduciaries, this presented a problem. “Section 404 of ERISA relates to the ‘Prudent Man Rule’ and has been responsible for a great deal of confusion regarding the appropriate composition assets. Generally accepted trust law, under the Prudent Man Rule, focuses solely on the risk of loss and on minimizing such risk on each security in a portfolio rather than on the portfolio as a whole.4 In 1978, “the Department of Labor issued a clarifying statement on Section 404 of ERISA which accepted the total portfolio approach…”5

It took nearly two decades for asset allocation to go from a “well, OK” endorsement from the DOL to the nearly de facto industry standard. Rather than a gradual movement, the use of asset allocation accelerated like a rocket following the (ironically) misinterpret of a famous research paper.

Asset Allocation’s Holy Grail
With asset allocation, picking stocks did not matter. Indeed, a controversial paper published in 1991 is still regularly misquoted to conclude asset allocation, not stock picking, drives investment performance. You’ll often see this inaccurately cited in financial ads that say “studies show 93% of investment performance comes from asset allocation.” As a result of misrepresenting this paper, the industry quickly shifted towards the mass marketing of investment products as part of the broader asset allocation complex. You see this every day in television ads, hear it every day in radio ads and read it every day in newspaper and magazine ads. So, you ask yourself, given the momentum supporting asset allocation, how can you determine if the Emperor has new clothes or not?

In 1991, Gary P. Brinson, Brian D. Singer, and Gilbert P. Beebower  published “Determinants of Portfolio Performance II,” (Financial Analysts Journal, May/June 1991). It was a follow up to an earlier (1986) research report (hence, the “II” in the title) by Brinson, L. Randolph Hood, and Beebower. Collectively known as “BHB,” the latter study concluded, “that investment policy explained, on average, 91.5 per cent of the variation in quarterly total plan returns.” Soon after, the industry began using the BHB to explain to investors that “more than 91 percent of a portfolio’s return is attributable to it mize of asset classes.” (Vanguard)6 and “91.5 percent of the difference between on portfolio’s performance and another’s is explained by asset allocation.” (Fidelity).7

There were two issues from BHB. The first is simply misinterpreting the conclusions of the research, like we saw above. Some are charitable in their assessment as to the motives of this mistake. “I think it is because many individuals don’t understand academic research and what the quantitative methods really mean,” says Robert R. Johnson, President and CEO, The American College of Financial Services located in Bryn Mawr, Pennsylvania.

Others see it as the use of a short-hand to make it easier for retail investors to understand. Ryan O’Donnell, Wealth Manager and Founding Partner of The O’Donnell Group located in Chico, California, says, “Risk and return are related and variability is another word for risk. As the MPT specifically allows you to plug in the known variables to determine the expected return. With all asset classes we can develop a ‘variability’ or ‘risk’ metric (standard deviation) and also therefore a return assumption. In that case variability is much harder to explain to the populous so return is used instead.” So, like much academic work, the translation to the broader public often sacrifices the accuracy of the conclusion.

Finally, many knowledgeable professionals prefer to see things more bluntly. “Like many studies, the BHB study on asset allocation has been widely misquoted due to advisors, among other institutions, spinning the data to their sales advantage,” says Alex Sylvester, Senior Account Executive at Assured Neace Lukens in Indianapolis, Indiana.

It’s difficult for these investment veterans not to be cynical when they see BHB taken out of context. Joe Gordon, a partner at Gordon Asset Management, LLC in Durham, North Carolina, says, “Most financial advisors, that is, over 92% likely, only have a license to sell and a little basic knowledge, so to them it is one and the same. A license without credentialing and experience is like a loaded gun in the hands of a so-called financial advisor.”

For many, the fault of this misinterpretation lies squarely in the realm of marketing, although, given the oversite of the investment sales process, it’s hard not to cite the compliance department as an accessory to this. “The BHB study is widely, and often wildly, misquoted because many advisors are simply parroting back something they (mis)heard and often without reading or understanding the underlying research,” says Michael Prus, President of Scale Investment Group in Detroit, Michigan.

Misinterpretation is one thing. There’s a greater issue with BHB, one which calls into question its (accurately stated) conclusion.

The Broken Chalice
Almost from the beginning, other industry researchers and practitioners questioned the veracity of its claims. Both Yale Emeritus Professor Roger Ibbotson, Chairman and CIO at Zebra Capital and Founder of Ibbotson Association (“Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?Financial Analysts Journal, January/February 2000) and David Larrabee, Director, CFA Institute, Charlottesville, Virginia, (“Setting the Record Straight on Asset Allocation,” CFA Institute, February 16, 2012) have written excellent perspectives on these challenges.

Johnson says, “What BHB studied were broadly diversified funds with limited market timing. They concluded that, over time, 92% of the variability in returns were explained by asset allocation. In lay terms, a rising tide floats all boats. Others have debunked that thinking by suggesting that with more actively managed funds, security selection has a much larger influence than 8%. The unfortunate interpretation of the BHB results is that active management can’t have a major impact on returns. One has to look no further than Berkshire Hathaway to see the importance of security selection. Before Berkshire became largely a conglomerate of operating businesses, the success of Berkshire was due to Mr. Buffett’s security selection prowess. Perhaps a large percentage of variation of average diversified funds is due to asset allocation, but market forces weren’t responsible for Berkshire’s success relative to the market.”

Larrabee addressed the earlier issued when he tells, “While I wouldn’t want to impugn the motives of those who have misquoted the BHB conclusion, I suspect that this misunderstanding may be marketing-driven. Dismissing the importance of active management (stock selection and market timing) and suggesting that returns were largely due to asset allocation made for an easy story to tell (and sell), so perhaps the industry simply heard what they wanted to hear.”

Ibbotson’s research, however, seriously questions whether the “90%” number is even appropriate, given what BHB actually measured. He led a group that looked at the BH study from the point of view of mutual funds (rather than the pension plans BHB used) and came up with several different answers as to how much influence asset allocation really has. Still, while being circumspect as to the way it’s being used, he remains sympathetic to what was going on in the industry during the 1990s and how it used BHB. “People respected Jerry Brinson,” say Ibbotson, who also co-authored a book with Brinson, “but also it was a nice answer to the overemphasis of stock selection. There was a big shift taking place in the RIA community from individual stocks to big picture items. This was easier. It was the right answer to meet the needs of the times, and continues so today. It was the right thing to do, but it’s overstated.”

We must also recognize exactly which groups of professionals saw the BHB study as relevant. “Most institutional portfolio managers are focused on buying and selling securities within a single asset class,” says Larrabee. “Financial planners serving a retail client base typically emphasize asset allocation as part of their investment process. Because they are buying primarily mutual funds and ETFs, there is less of a focus on security selection among most financial planners.”

This might be why the BHB myth has survived as long as it has. Ibbotson says, “The stock pickers don’t even want to enter into the discussion so there influence is less. There’s been a shift from stock pickers to mutual fund pickers and their influence has diminished.”

“Roger Ibbotson’s hypothesis certainly has merit and helps to explain why portfolio managers have left the BHB myth go largely unchallenged,” says Larrabee. “I would also posit that there are many portfolio managers who simply haven’t found the BHB myth to be an obstacle in attracting assets. There are enough investors, institutional and retail, who believe in active management, so it’s an argument that stock pickers, especially the good ones, haven’t have to make.”

Still, True Believers are Hard to Sway

For many, BHB represents the keystone of asset allocation. Yet, despite the refutation of BHB, it’s hard to for many to connect the dots. That may be because they don’t truly believe BHB has been disproven. It has become not of question of “if” it’s used, but “how” it’s used. “I happen to believe that asset allocation does work and should be used by most investors,” says Murray Carter, CFP, Executive VP – Wealth Management, CSG Capital Partners of Janney Montgomery Scott, says. “The bigger question is what allocation is right for each investor. Unfortunately, most investors believe they are able to assume risk when their portfolios are rising. It is only during periods of decline that they then understand what risk truly is and then are apt to panic, making poor decisions at market inflection points.”

It may be that asset allocation is so integrated into the framework of financial planning and investment management it’s difficult to suspend one’s disbelief regarding its merits. O’Donnell says, “It is the bedrock for developing a portfolio. If any fiduciary tries to claim otherwise they’re basing that information ‘hunches and sure fire bets.’”

We’ll test this idea in the next two installments.

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.

1Pickering, Octavius (1831). Harvard College and Massachusetts General v. Francis Amory. Reports of Cases Argued and Determined in the Supreme Judicial Court of Massachusetts, Vol. IX (Boston: Hilliard, Gray, Little and Wilkins). p.461
2Ibid., p.461
3Bodie, Zvi; Alex Kane; and, Alan J. Marcus, Investments, Richard D. Irwin, Inc., 1989, p. 3
4Cohen, Jerome B.; Edward D. Zinbarg; and, Arthur Zeikel, Investment Analysis and Portfolio Management, 5th Edition, Richard D. Irwin, Inc., 1987, p. 554
5Ibid., p. 555
6Ibbotson, Roger G.; and, Paul D. Kaplan, “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal, January/February 2000 (attributed to “‘Asset Allocation Claims – Truth or Fiction?’ Jennifer A. Nuttall and John Nuttall (unpublished) 1998”)
7 Ibid.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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