After the market crash of 2008-2009, many investors were tossing in the towel on asset allocation, suggesting that it had major flaws as evidenced by nearly every asset class moving significantly lower in apparent lockstep.
The fundamental premise behind asset allocation is to take one's investments and choose among the various asset classes available to the investor. Based on the needs of the investor, the implementation of the allocation process requires the investor to decide how much of their assets should be dedicated or allocated to any given class. This decision is not easy, and investors and their financial professionals should evaluate each class that is within the individual investor's tolerance for risk, time frame, investment needs, goals and objectives, and investment experience.
The theory behind asset allocation is that by diversifying among different asset classes, you are decreasing your overall investment risk and volatility. It should be noted, and has been found, that asset allocation does not guarantee against a loss or a decrease in an investor's portfolio.
It is widely believed that many various asset classes frequently behave in what is called a "non-correlating" manner. This means that different asset classes may perform differently from one another in the same market conditions. This, of course, is based on historical analysis, and as we learned in the crash of 2008, these historical precedents may not always be true in the future.
When you think of asset classes, it's necessary that you look way beyond types of products such as stocks, bonds and cash. Stocks, for example, now need to be considered in terms of both U.S. stocks and international offerings. Allocations may even be broken down as far as the specific countries in which to invest. Then, in addition to the country or international flavor that investors are looking for, there are even more ways to slice and dice your equity asset allocation.
CLASSES OF STOCK
Stocks can also be sliced and diced in terms of "market cap." Market cap is short for market capitalization, which is deemed the fair market value of the company. It is typically determined by multiplying the total shares outstanding by the price per share. In the U.S., stocks are broken down into three different categories in terms of size. "Small cap" stocks are generally those whose market capitalization is less than $2 billion. "Mid cap" stocks are those whose value is greater than $2 billion, but less than $10 billion. And "large cap" stocks are those with market caps of greater than $10 billion.
Another way to slice your stock allocations is by sector, or the industry that a particular investment represents. In the Standard and Poor's 500 index, which is the index generally considered representative of the broad market, there are 10 broad sectors represented, which are known as the S&P Global Sector Indices. These sectors represent the output of companies, and include:
Consumer discretionary;
Consumer staples;
Energy;
Financials;
Health care;
Industrials;
Information technology;
Materials;
Telecommunication services; and,
Utilities.
A well-thought-out equity-based portfolio, as you can see, can go well beyond the percentage that you should have allocated to equity positions. It can include exposure to as many of the various sub-categories as is appropriate for your individual client.
BONDING WITH BONDS
The same holds true for bonds. Nearly everyone knows that bonds are debt instruments, also known as fixed-income investments. Bonds are called fixed income because of the coupon rate printed on the bond that details the rate of interest or the method in which yield shall be calculated. But today there are some very creative and clever bond offerings that offer anything but a fixed income. There are bonds whose coupon rates change at a particular time in the future. Many bonds also have call features, where the issuer is reserving the right to either pay off the bonds early from profits or to refinance the bonds by issuing newer bonds at a lower rate at some point during the bonds' lifetime. The issuer may be able to obtain a lower rate simply if market rates go lower or if their credit rating improves to justify a lower interest cost to the borrower.
Beyond the coupon rate on the bond, bonds have sub-asset classes as well. Bond allocations may vary between the country of origin, the issuer and their corresponding credit rating and the time frame of the bond. As with stocks, investors can consider owning more than just one asset class of bonds based on their situation. Varying bond holdings in terms of duration, quality and type of issuer can be prudent for an investor looking to diversify their holdings. Owning short-term through long-term bonds may be appropriate for some. Owning the highest-quality rated bonds through lower-quality (or higher-risk) bonds may make sense for others. Allocations can also include issuers ranging from the U. S. government or a multitude of state, local or foreign governments, through companies both large and small. With bonds, the more risk you take is generally matched through a higher listed rate of interest on the bond.
DON'T FORGET CASH
Cash is also considered an asset class. Those with excess cash holdings almost always have the comfort of knowing that their investment is not subject to investment risk. But cash is not going to show you any great gains, either - especially in today's low-interest-rate environment. If fact, it doesn't take a math major to figure out that most cash-equivalent investments in recent years have been yielding less than the core rate of inflation, and therefore have been subject to inflation or purchasing power risk. This also means that most cash allocations today can effectively reduce the purchasing power of an investor's savings.
But beyond these three basic asset classes, there are other classes that have been made available to the institutional investment community that are now finding their way to the retail-level investor. These classes are commonly called alternative asset classes, and include:
Real estate;
Natural resources or commodities;
Precious metals;
Foreign currency;
Collectibles such as coins, art or antiques; and,
Private equity.
Many of these investments require a pre-qualification of clients in terms of sophistication, experience in investing, and amount of investment subject to high risk, since these classes tend to be more volatile than the three core asset classes. There are additional risks of liquidity (getting money out of an investment), which may prevent investors from recovering some or all of their investment in a downturn. This volatility tends to heighten investors' emotions and may influence their decisions. Examples of this include the real estate bubble and today's almost frenzied pace of investors looking for exposure to gold. The rapid rises of precious metals have many investors coming to buy gold, which may not necessarily be consistent with a sound asset allocation methodology.
When it comes to the asset allocation strategy, one may ask about how to make a decision regarding which classes to own and when to sell. Understand that there is no correct answer here, just guidelines and differing methodologies.
SHAPING THE PORTFOLIO
This decision tree starts with which investments will make up an investor's allocations. In fact, there are different types of management within certain investments. Actively managed investments are those where the manager actively manages the chosen holdings in the fund, and passively managed investments are often designed to mirror a particular index without regard to the specific holdings and representing every individual holding within that sector.
Neither methodology is better. Investors believe in either active management or passive management. Some believe in both active and passive management and color their judgment by market cycles. In bull markets, they may want the lower cost and tax advantages of passively managed investments. In bear or choppy markets, they may want active managers who can "cherry pick" their holdings.
Another, even deeper decision is what sectors, market caps or other asset classes to own. This decision could be made based on strategic thinking or tactical thinking. Strategic thinking relies on broad economic conditions currently and those forecast for the future. Tactical thinking may also use some economic data, but it attempts to judge the price direction among the asset classes and sectors, and own only those headed in a positive direction.
Strategic thinking is where most financial planners sit. They pretty much make their allocations, tweak them on a regular basis, and buy and hold according to the optimal allocation of asset classes based on past performance of the markets. This method came under a lot of pressure during 2008 and 2009, as it did during the tech meltdown during the earlier part of the decade.
MARKET TIMING
Tactical investing, sometimes incorrectly called market timing, is an attempt to own appreciating asset classes while avoiding losing asset classes. In practice, it is very hard to do consistently. Having worked with clients dating all the way back to the 1987 crash, I can tell you that some sort of tactical approach has resonated with clients. There are many research firms that provide tactical information to help money managers make their decisions.
The last and perhaps the most important question is whether advisors consider themselves an asset manager, picking the funds, stocks, bonds and other asset classes. The alternative is what is called an asset gatherer, a manager of managers, allowing full-time investment professionals to actually decide both the allocations and the tactical timing of your holdings. There are firms whose only mission in life is to serve the investment needs of financial advisors in a cost-effective and customized manner.
Here again, there is no wrong or right. But there is compelling evidence that the trend is leaning towards financial advisors being asset gatherers.
Being a money manager is a full-time job. It is hard enough to be a money manager and a fantastic financial advisor. It is even more difficult if you have to add accounting and tax tasks to your to-do list. While there are some who really believe that they can be a great fiduciary in all three areas, I don't agree. I wonder just how good the Beatles would have been if Paul had to play the bass, lead guitar and drums?
John P. Napolitano, CFP, CPA, PFS, is chairman and CEO of U.S. Wealth Management in Braintree, Mass.
