A Modern Approach to Asset Allocation and Portfolio Construction

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Schwab Center for Financial Research A Modern Approach to Asset Allocation and Portfolio Construction Anthony B. Davidow, CIMA Vice President, Alternative Beta and Asset Allocation Strategist Schwab Center
Schwab Center for Financial Research A Modern Approach to Asset Allocation and Portfolio Construction Anthony B. Davidow, CIMA Vice President, Alternative Beta and Asset Allocation Strategist Schwab Center for Financial Research James D. Peterson, PhD Senior Vice President, Chief Investment Officer Charles Schwab Investment Advisory, Inc. Asset allocation dividing an investment portfolio into different asset classes, such as large-company stocks, smallcompany stocks, international stocks, bonds, commodities, cash investments, etc. has been the cornerstone of investment planning for decades. The goal of asset allocation is to reduce risk through diversification by having exposure to a variety of investments that perform differently during various market conditions. In recent years, though, we ve seen higher correlations or more movement in tandem between asset classes during periods of market stress. Some are questioning the value of asset allocation and the merits of Modern Portfolio Theory (MPT), which states that optimal portfolios can be created by considering the relationship between risk and return. It is important to understand that asset allocation still helps investor portfolios even during times of market turmoil. In fact, as long as assets aren t moving in perfect lockstep, the longstanding benefits of diversification still hold true. 2 However, we believe that investors should consider adapting their asset allocation strategies to account for higher correlations and new investment choices. The rise of non-traditional asset classes such as commodities, as well as, expanded stock and bond sub-asset classes, has given investors additional diversification options. At the same time, mutual funds and exchange traded funds (ETFs) have given individual investors low-cost vehicles to pursue opportunities once confined to institutional investors. Charles Schwab & Co, Inc. has evaluated the asset allocation approaches used in the market today. This paper outlines our views about the appropriate asset mix for different types of investors, and explains the process of constructing a diversified portfolio based on those views. It also highlights the benefit of making controlled tactical shifts within each asset class to respond to fluctuating market and macroeconomic conditions. 3 Table of contents Section I. Traditional asset allocation 1. More than the sum of the parts 2. Ongoing evolution Section II. New market realities 1. Assets are more correlated 2. Increased external shocks 3. Equity risk dominates traditional asset allocation 4. Bond yields are low 5. Expected stock returns are lower Section III. Adapting asset allocation to changing times 1. A modernized asset allocation for individual investors 2. Which assets should be included? 3. Where does each asset class fit in the portfolio? a. The role and usage of commodities Section IV. What is the optimal mix? 1. Total return models 2. Income models 3. Tactical shifts Section V. Portfolio construction: Putting the pieces into place 1. Evaluating equity choices 2. Customizing allocations 3. Fixed income considerations 4. Evaluating active managers 4 I: Traditional asset allocation Asset allocation forms the basis of Schwab s investment philosophy. By providing a framework for deploying capital over a mix of investments, asset allocation allows investors to diversify their holdings and help mitigate downside risk. This built-in benefit is a well-known feature of asset allocation, and it makes intuitive sense when one asset class suffers, it pays to not have all your eggs in one basket. But there s another advantage to asset allocation that is not understood as clearly: the potential to grow wealth. An appropriately allocated portfolio helps smooth out the ups and downs of the market so investors can enjoy the positive compounding of returns over time. 1.) More than the sum of the parts Consider the following example with two investments: $100 invested in U.S. large-company stocks (as represented by the S&P 500 Index) at the beginning of 1970 would have grown to $7,771 by the end of $100 invested in commodity markets (as measured by the S&P GSCI Index) would have grown to $4,829 over the same time period. But if that $100 had been invested in a split of both investments, the portfolio would have grown to $9,457 over the same span. This return is 20% more than the stock portfolio alone and almost double the return of the commodity portfolio, while demonstrating lower average risk (see Exhibit 1). While stocks and commodities are both deemed relatively risky investments, combining them helps mitigate the risk of the portfolio. This is due to their relatively low correlation to one another. 5 Exhibit 1: Risk/ return profile of $100 investment: Portfolio value $10,000 $9,000 $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 S&P % average annual return 17.6% risk S&P GSCI 9.2% average annual return 24.3% risk 50/50 Portfolio with annual rebalancing 10.9% average annual return 14.5% risk $9,457 $7,771 $4,829 $2,000 $1,000 $ * Risk is measured as the standard deviation of annual returns Source: Charles Schwab Investment Advisory, Inc. and Morningstar Direct. The example is hypothetical and provided for illustrative purposes only. It is not intended to represent a specific investment product. Dividends and interest are assumed to have been reinvested, and the example does not reflect the effects of fees or expenses. If fees and expenses had been included, returns would have been lower. Past performance is no guarantee of future results. The difference that a diversified portfolio can deliver over the sum of its parts is what Nobel Prize winning economist Harry Markowitz once called the only free lunch in finance. In other words, diversification can deliver benefits over time at no additional cost. This free lunch is made possible by the fact that individual assets typically aren t perfectly correlated. If asset values do not move in perfect harmony, then a diversified portfolio will have less risk than the weighted average risk of its constituent parts. In fact, a diversified portfolio can often have less risk than its lowest-risk constituent, as it does in the example. The reason lower portfolio risk can lead to higher wealth in the long run is that a portfolio with lower risk generally does not decline as much in a market downturn, so it can recover more quickly than a riskier portfolio that has declined sharply. For example, a portfolio that falls in value by 25% must grow by 33% to recover from its loss. But a portfolio that declines by 10% only needs to grow by 11% to fully recover. 2.) Ongoing evolution Markowitz first introduced the concept of diversification in Markowitz s work, which served as the foundation for MPT, concluded that an investor could reduce the overall risk of a portfolio by including investments that have low correlations to one another. 1 1 Markowitz, Harry, Portfolio Selection, Journal of Finance, March Since then, others have built upon this core premise. In 1964, Bill Sharpe introduced the Capital Asset Pricing Model (CAPM), which described the relationship between risk and expected return, and introduced beta as a measure of sensitivity to market risk. 2 Markowitz and Sharpe won the Nobel Prize in Economics in 1990 for their significant contribution to MPT. In 1986, Gary Brinson, Randolph Hood and Gilbert Beebower studied the allocations of 91 pension funds and concluded that asset allocation decisions, on average, explained more than 90% of pension fund risk, as measured by the volatility of returns over time. 3 In 2000, Roger Ibbotson and Paul Kaplan showed that a large portion of the variation in time-series returns comes from general stock market movements, not the specific asset allocation decision. More importantly, they correctly point out that many investors mistakenly believe that the Brinson, Hood, and Beebower result applies to the return level. They argue that because, on average, investors do not beat the market (the average return of those who do beat the market is offset by the average return of those who don t), asset allocation policy explains 100% of the typical individual investor s level of return. 4 While some challenged these findings over the years, it wasn t until after the 2008 financial crisis that the merits of MPT were widely questioned. Critics pointed to higher correlations between asset classes during periods of market stress essentially undermining diversification benefits when investors need them the most. As we examine the role of asset allocation in investor portfolios today, it s important to understand that even during periods of market stress, diversification still makes sense as long as assets don t move in perfect lockstep. It s also important to recognize that asset allocation strategies can be dynamic both in choosing which asset classes to include and in making tactical adjustments to reflect short- or long-term changes in the market or macroeconomic environment. 2 Sharpe, William, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk, Journal of Finance, September Brinson, Gary, Randolph Hood, and Gilbert Beebower, Determinants of Portfolio Performance, Financial Analysts Journal, July August 1986, Ibbotson, Roger and Paul D. Kaplan, Does Asset Allocation Policy Explain 40%, 90% or 100% of Performance? Financial Analysts Journal, January-February 2000, II: New market realities MPT needs to evolve further to reflect new market realities and the ongoing expansion of asset allocation to non-traditional asset and sub-asset classes. Taken together, these realities have significant implications for investors. 1.) Assets are more correlated The diversification benefits associated with combining assets into a portfolio are driven primarily by how closely the returns on those assets move together, and correlation is a statistical measure of that relationship. When two assets are perfectly positively correlated, they have a correlation of +1. They move in perfect harmony, so there are no benefits from combining them in a portfolio. When two assets are perfectly negatively correlated, they have a correlation of -1. In this case, combining the two assets into a portfolio can eliminate all risk. A correlation of zero means that the two assets are uncorrelated. In this case, they don t move together at all and there are substantial benefits to diversification, but risk cannot be completely eliminated. In reality, no two assets are perfectly correlated either positively or negatively. In practice, most correlations are positive, and investors should seek investments with lower correlation to one another. Relatively few assets have low or negative correlations with each other. As noted before, assets have become more highly correlated in recent years. We examined correlations for four equity asset classes over three different time periods (see Exhibit 2). We found that correlations have generally been rising since (as seen below by the increasing amount of red and orange squares). This means that diversification benefits have been decreasing over time. Exhibit 2: Equity correlations have been rising U.S. large-company stocks U.S. small-company stocks International large-company stocks Emerging markets stocks Low correlation High correlation Moderate Moderately high High Greatest diversification Little diversification Source: Charles Schwab Investment Advisory, Inc. and Morningstar Direct. 8 We believe that correlations have been rising due to greater inter-connectivity between global markets. Multinational corporations have proliferated to such an extent that what happens in Europe and Asia impacts the U.S. markets and vice versa. Many Fortune 100 companies in the United States depend on emerging markets for growth; and many overseas corporations depend on demand from American consumers. In addition, access to more information via the Internet is fueling the inter-connectivity. In 2008, correlations increased due to the global credit crisis. Indeed, if you look at the history of financial markets, you will find that correlations tend to rise in times of crisis. Even as we put more distance between the 2008 financial crisis and the present, we believe that correlations in equity markets will remain elevated going forward. This does not rob diversification of its merits it simply means that it will be more nuanced. Instead of looking for uncorrelated investments, we ll focus on slight reductions in correlation. For example, investments with a correlation of 0.5 provide greater diversification benefits than those with a correlation of 0.7, and the diversification benefits increase as the correlations decrease. 2.) Increased external shocks One major repercussion of global interconnectivity is that markets are hit by more external shocks. Major market-moving shocks have increased in number and intensity in recent years. Events like the European debt crisis, the Japanese tsunami of 2011 and government change in Ukraine have unnerved investors and affected the outlook for companies across the globe. Another factor contributing to this dynamic is how quickly information spreads within and across markets (impacting correlations as well). Individual investors and smaller institutional investors now have access to information once available only to large institutional investors, but they have less time to digest it. Hedge funds and high-frequency traders can respond to news immediately, creating big swings in individual stocks and market segments. This tendency to act quickly on breaking news contributes to market volatility during times of crisis or unease. 9 3.) Equity risk dominates traditional asset allocation The traditional approach to asset allocation has been to allocate 60% to stocks and 40% to bonds and cash. However, stocks tend to be much riskier than bonds. Equity risk, as represented by the standard deviation of the S&P 500 Index, is much higher than bond risk, as represented by the Barclays Capital U.S. Aggregate Bond Index. Therefore, it s important to recognize that equity risk dominates the risk of traditional asset allocation. As we will discuss later, modern approaches to asset allocation seek to achieve a better balance of risk-taking and reduce the amount of equity risk in the portfolio. 4.) Bond yields are low Most investors buy bonds for their return of principal, barring default, and for the income they generate. Long-term interest rates, as measured by the yield on the 10-year Treasury bond, have declined dramatically since the mid-1980s (see Exhibit 3). Exhibit 3: Bond yields are low 14% 12% 10-year Treasury yield 10% 8% 6% 4% 2% 0% Source: Charles Schwab Investment Advisory, Inc. and Bloomberg. 10 With interest income at generational low levels, investors have sought other sources of income. A reality of the current low interest rate environment is that many investors in or near retirement will not be able to generate sufficient interest income from investment-grade bonds alone, further diminishing their appeal. Most market prognosticators, including us, believe that bond yields are more likely to rise than fall going forward, which means that bond prices are more likely to fall. This is especially true for Treasury and mortgage bonds since the Fed has been purchasing bonds in these sectors to keep long-term rates low. Once this stimulus is removed, it is likely that bond yields will rise. Therefore, we have evaluated the addition of other fixed income investments to our asset allocation models, including high-yield, international, and emergingmarket bonds. 5.) Expected stock returns are lower A low Treasury yield also generally implies low expected stock returns. This is because the expected return on stocks can be thought of as the expected return on a default risk-free security (like U.S. Treasury bonds) plus an equity risk premium. Merely extrapolating from stocks and bonds long-term historical results will not be sufficient for asset allocation models going forward. In sum, it s not just higher correlations that are prompting many to consider their asset allocation strategies going forward. There are plenty of reasons why investors should revisit their allocation models to ensure they are realizing the full potential of diversification. III: Adapting asset allocation to changing times In response to these changing economic conditions, asset allocation has evolved a great deal from the typical stocks, bonds and cash blend popular during the 1990s (as shown in Exhibit 4). Modern asset allocation now encompasses non-traditional asset classes, like commodities. In addition, it is now common to divide stocks and bonds into a variety of sub-asset classes. Stocks can be broken up into large and small, domestic and international, and developed and emerging markets. Bond allocations can include Treasuries, agencies, investment-grade corporate bonds and high-yield bonds. 11 Exhibit 4: Sample of a modern approach to asset allocation Asset allocation 1990 s Asset allocation today Stocks (equities) U.S. investment-grade bonds Cash For illustrative purposes only Source: Schwab Center for Financial Research. Large-company stocks Small-company stocks International stocks Emerging markets stocks Corporate bonds High-yield bonds Government bonds Commodities REITS TIPS Cash To meet their long-term needs and objectives, institutional investors have adopted different approaches to incorporating a wider range of asset and sub-asset classes. These include: The Endowment Model, based on the extraordinary results delivered by endowments managed by Yale University and others in the late 1990s and early 2000s. Yale, Harvard and other large endowments allocated about 70 80% of their portfolios to alternative investments, including private equity, real estate, timber and absolute return strategies. The Liability-Driven Investment (LDI), a holistic investment strategy based on cash flows needed to fund an institution s unique future liabilities, which tends to rely on bonds. The Risk Parity approach, in which each asset class is assigned a weight such that it contributes equally to the overall risk of the portfolio. This approach lends itself to large allocations to fixed income. 12 While these asset allocation approaches have proven successful for institutions, most individual investors time horizons are much shorter. They also lack the dedicated resources and access to many of the investments available to institutions. 1.) A modernized asset allocation model for individual investors At Charles Schwab, we believe investors deserve the same opportunities as institutions when it comes to tailoring their investments to their individual risk appetites, needs and goals. With the expansion of asset classes and the increased number of ways to gain exposure, it s important for individual investors to rethink their asset allocation. After evaluating the asset allocation approaches used in the market today, Schwab has developed its own point of view on asset allocation models. Our perspective embraces aspects of three different asset allocation philosophies: Traditional diversification: Asset class weights are chosen so as to maximize the expected return for a given level of risk. Risk budgeting: Weights are assigned to asset classes with the goal of diversifying the sources of risk across multiple asset classes. Goal driven: Asset allocation is designed to achieve a specific goal, such as absolute return, inflation hedge or income. Success is measured by the achievement of a specific target, such as income. While our approach relies heavily on MPT, we recognize that investors often feel more strongly about avoiding losses than acquiring gains. As a result, we have incorporated a preference for loss aversion in the portfolio construction process. In addition, we know that many retired investors prefer to live off t
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