1

Using the Latest Asset Allocation Techniques to Benefit Your Portfolio

Presented at IIR’s Understanding Asset Allocation and Investment Policy Conference Design for Pension Funds

June 19, 2000

Michael D. Smith, CFA

Research Director

Hewitt Investment Group

Hewitt

2

Asset Allocation

Asset Allocation Overview• Importance of asset allocation.

• Risk tolerance.

• Impact of investment time horizon on risk tolerance.

• Diversification principles.

• Definition of asset classes.

• Assumption setting for asset classes.

• Limitations of modeling for asset allocation.

• Asset allocation in the context of liabilities.

• Rebalancing policy.

3

Importance of Asset Allocation

How Much Does Asset Allocation Explain?• The correct answer is that it depends on how you ask the question.

• Following the Brinson/Beebower studies in 19861 and 19912, most people answer 90%.

• The Brinson study asked what percentage of the variability of return was explained across time by asset allocation.

• The formulation regresses a fund’s monthly return against the monthly return of its policy benchmark.

• There are more interesting questions worth asking!

• Earlier this year Roger Ibbotson3 repeated the Brinson analysis, and asked and answered two new questions.

4

Importance of Asset Allocation

Asset Allocation and Return Variability Across Time• Ibbotson’s study examined 94 U.S. balanced mutual funds and 58 pension

funds.

• The answer to the question of variability across time is confirmed by Ibbotson, but the impact of active management and capital market exposure is demonstrated.

Time-Series Regression Studies

Brinson 1986 Brinson 1991 Mutual Funds Pension Funds

R2 93.6% 91.5% 81.4% 88.0% Mean NA NA 87.6% 90.7% Median

Active Return (Annualized) Mean -1.10% -0.08% -0.27% -0.44% Median NA NA 0.00 0.18%Source: Ibbotson (2000).

5

Importance of Asset Allocation

Asset Allocation and Return Variability Among Funds• While many people still refer to Brinson’s 90% to answer this question, the

true answer is much different.

• To answer this question, Ibbotson regressed the 10-year compound annual return for each fund against its policy return.

• For mutual funds, asset allocation explained only 40% of the return difference for mutual funds, and 35% for the pension funds.

Cross-Sectional Distribution of Balanced Mutual Fund Policy Weights

Large Cap Small Cap Non-US Stocks U.S. Bonds Cash

Average 37.4% 12.2% 2.1% 35.2% 13.2%

75th Percentile 48.8% 16.5% 3.1% 45.1% 17.5%Median 40.2% 11.0% 1.5% 35.2% 7.7%25th Percentile 29.9% 7.1% 0.0% 26.6% 1.0%Source: Ibbotson (2000).

6

Importance of Asset Allocation

Asset Allocation and Return Level• The is probably the most important question of the three, and the answer is

higher than convention wisdom.

• To answer this question, Ibbotson simply took the ratio of the policy return to the fund return for the full period.

• The results show the asset allocation accounts for about 100% of fund returns.

Percentage of Total Return Level Explained by Asset Allocation

Brinson 1986 Brinson 1991 Mutual Funds Pension Funds

Average 112% 101% 104% 99%

95th Percentile NA NA 82% 86%75th Percentile NA NA 94% 96%Median NA NA 100% 99%25th Percentile NA NA 112% 102%5th Percentile NA NA 132% 113%Source: Ibbotson (2000).

Skewed MFdistribution

7

Asset Allocation

The “Big Picture”

Capital Market

Expectations

RiskTolerance

Asset

Allocation

Funding

Goal

8

Asset Allocation

The “Big Picture”• The goal of the asset allocation process is to select an “optimal” portfolio of

assets given a plan’s risk tolerance and capital market expectations.

• Risk tolerance includes factors such as:— Time horizon;— Demographics;— Plan design;— Funded level; and— Ancillary goals.

• Typically, assets are modeled with a “mean/variance” optimizer, and the results are integrated with liability modeling.

• Goal analysis determines the probability of achieving various funding targets.

• The most important result for asset allocation is the target level of equity exposure.

9

Asset Allocation

Risk Tolerance Public Pensions• There are three major determinants of risk tolerance for a public plan:

• Business and financial position.— Ability to get additional contributions if investments perform poorly in

the short-term;

• Workforce demographic characteristics; and — Average age and years of experience, active/inactive ratio, retiree

liability to plan assets (i.e., duration of liabilities).

• Actuarial and funded status.

— Funded ratios, actuarial smoothing, actuarial assumptions.

10

Asset Allocation

Risk Preference • The complete risk posture of a plan is more than the hard numbers.

• Risk preference incorporates the psychological stance of the plan sponsor, along with ancillary goals.

• Risk preference includes factors such as:— The importance of short-term losses versus the chance of long-term

gains;

— The importance of plan value versus long-term funding;

— Predictability of returns versus long-term results.

• Ancillary goals may include desired improvements in pension benefits, credit rating goals, tax policy goals, or “excess interest” account considerations.

11

Asset Allocation

Risk Posture

Business and Financial Characteristics

Demographic Characteristics

Actuarial and Funding Characteristics

Risk Preference

Below Average Average Above Average

Overall Risk Posture

12

Asset Allocation

What is Risk?

• Volatility • Sovereign risk

• Counter-party risk • Tracking error risk

• Credit risk • Career risk

• Interest rate risk • Peer risk

• Inflation risk • PR risk

• Model risk • Tax rise risk

• Liquidity risk

13

Performance of Best Asset Class Annual Returns

38.6%

16.6%

33.8%

29.1%

15.1%

56.7%

69.9%

24.9%

34.9%

61.5%

9.0%

46.1%

18.4%

79.6%

8.1%

37.4%

23.1%

33.4%

28.9%

43.1%

66.4%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

EmergingMarkets

U.S. Large

U.S.Small

Int’l Equity

HY Bonds

RealEstate

U.S. Bonds

14

Performance of Best Asset Class Annual Returns

38.6%

16.6%

33.8%

29.1%

15.1%

56.7%

69.9%

24.9%

34.9%

61.5%

9.0%

46.1%

18.4%

79.6%

8.1%

37.4%

23.1%

33.4%

28.9%

43.1%

66.4%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

EmergingMarkets

U.S. Large

U.S.Small

Int’l Equity

HY Bonds

RealEstate

U.S. Bonds

15

Asset Allocation

Diversification — Asset Assumptions

Expected Return Components

0%

2%

4%

6%

8%

10%

U.S. Stocks International Stocks Fixed Income Real Estate

Liquidity Premium

Spread Premium

Risk Premium

Real Risk Free Rate

16

Asset Allocation

Diversification — Asset Assumptions

Expected InvestmentPerformance Correlation Coefficients

RealReturn

StandardDeviation LC SC I EM FI HY CE RE

U.S. Large Capitalization (LC) 7.0% 18.0% 0.85 0.65 0.60 0.45 0.55 0.25 0.05U.S. Small Capitalization (SC) 7.5 28.0 0.55 0.50 0.30 0.60 0.15 0.05International (I) 7.0 21.0 0.40 0.35 0.45 0.10 0.05Emerging Markets (EM) 8.0 30.0 0.30 0.40 0.05 0.05Total Equity

U.S. (FI) 3.5% 9.0% 0.75 0.60 0.10High-Yield (HY) 4.5 12.0 0.25 0.15Cash Equivalents (CE) 1.0 2.5 0.10Total Fixed-Income

Real Estate (RE) 5.0% 12.0%

Inflation 2.5% 1.5% -0.30 -0.20 -0.10 -0.10 -0.50 -0.35 -0.75 0.00

17

Asset Allocation

Diversification — Asset Optimization

Mean/Variance Optimization

4%

5%

6%

7%

8%

7% 9% 11% 13% 15%

Standard Deviation

Rea

l Ret

urn

18

Asset Allocation

Diversification — Asset Optimization

Mean/Variance Optimization

4%

5%

6%

7%

8%

7% 9% 11% 13% 15%

Standard Deviation

Rea

l Ret

urn

19

Asset Allocation

Diversification — Theory

Mean/Variance Optimization

4%

5%

6%

7%

8%

7% 9% 11% 13% 15%

Standard Deviation

Rea

l Ret

urn

20

Asset Allocation

Diversification — Theory and Practice

Mean/Variance Optimization

4%

6%

8%

10%

12%

14%

2% 4% 6% 8% 10% 12% 14% 16%

Standard Deviation

Rea

l Ret

urn

Practice

Theory

20% Large Stocks8% Small Stocks15% Int'l Stocks10% EM Stocks37% Bonds10% Real Estate

20% Large Stocks70% Bonds10% Real Estate

21

Asset Allocation

What is an “Asset Class”?

1970s 1980s 1990s 2000

U.S. Stocks Large Cap StocksSmall Cap StocksInternational Stocks

Large Cap StocksSmall Cap StocksInternational StocksREITs

U.S. StocksInternational Stocks

U.S. Bonds U.S. BondsInternational BondsHigh-Yield Bonds

U.S. BondsInternational BondsHigh-Yield BondsEmerging Market Bonds

Fixed Income

Real EstateTimberlandVenture Capital

Real EstateTimberlandVenture CapitalHedge Funds

Real Estate

Cash Cash Cash

22

Asset Allocation

What is an “Asset Class”? — Less is More

• Many asset/liability studies attempt to model too many “asset classes.”

• Mean/variance optimizers are referred to as “error maximizers” for a reason.

• The “Mini-max” approach models the “big picture,” and leaves the finer distinctions to implementation.

23

Asset Allocation

Why “Mini-max”?• Small estimation errors can lead to vastly different portfolios.

• There are only a few assets from which we have sufficient history to draw summary statistics.

• “Assets” with little or no passive alternatives and high dispersion are particularly poor choices for modeling.

• Minimize the maximum damage that estimation errors can do to modeling results.

24

Asset Allocation

Why “Mini-max”?

6.55% Return, Minimum Variance Portfolio

6.55% Return, Minimum Variance Portfolio

Expected Small CapPremium

LC SC IE FI RE SC/Total Equity

-0.50% 41% 0% 27% 22% 10% 0%0.00% 35% 5% 27% 23% 10% 7%0.50% 25% 13% 25% 27% 10% 21%

Expected InternationalPremium

LC SC IE FI RE IE/Total Equity

-0.50% 47% X 31% 12% 10% 40%0.00% 45% X 30% 15% 10% 40%0.50% 43% X 29% 18% 10% 40%

25

Asset-Liability Interaction

Higher Nominal Benefits

HigherLiabilities

HigherInflation

HigherPay

Increases

Lower (Present

Value of) Liabilities

Higher Discount

Rate

Higher Interest

Rates

Lower Value of Financial

Assets

26

Process of Asset-Liability Analysis

AssetMix

PortfolioReturn

Liabilities

DemographicsPlan Design

ActuarialAssumptions

ContributionsFunded Ratio

Expense

Inflation

InterestRates

Correlation

FAS 87DiscountRate

SalaryIncreases

Duration

27

Good Reasons for Conducting an Asset-Liability Study

• Developing Strategic Asset Allocation Policy

— Equity exposure level

— Duration of bonds

• Pension Planning

— Funding policy

• Understanding Cost and Benefits in Tangible Terms

— Cash costs

28

Wrong Reasons for Conducting an Asset-Liability Study

• Evaluating Modest Changes to Sub-asset Classes, e.g.

— Small cap stocks

— Emerging market equities

29

Potential Pitfalls in Conducting Asset-Liability Studies (and how to avoid them)

Problem Exclusive focus on a single variable, e.g., Surplus

Solution Focus on “True Economic Cost”

Problem Not everything has a “random walk”

Solution — Take into account autocorrelation of inflation and interest rates

Problem Assets and liabilities are not truly integrated

Solution — Use Monte Carlo simulations to generate assets and liabilities simultaneously

30

Potential Pitfalls in Conducting Asset-Liability Studies (and how to avoid them)

Problem Focus on summary statistics, e.g., mean and variance

Solution Focus on the entire distribution of outcomes

Problem Asset-liability results are “all over the place”

Solution Conduct goal-oriented analysis

31

True Economic Cost

• True Economic Cost = PV of Change in Funded Status

(times) Value Multiplier

(minus) PV of Contributions

• Value multiplier can range between 0 and 1

• Typically very well funded plan would assign a lower value to the multiplier

32

Goal Analysis

Don’t just evaluate the risk (variance) and expected return (mean), evaluate your ability to meet specific goals

Examples

• Minimize True Economic Cost over 10 years

• Keep funded ratio above 100% in each year

• Keep cash contributions below $10 million

• Hold contributions at current levels while adding COL adjustments.

33

Asset Allocation

Diversification — The Role of Rebalancing

Diversification Example — No Rebalancing

Diversification Example —With Rebalancing

Asset Year 1 Year 2 Cumulative

Stocks 20.00% -10.00% 8.00%Bonds -10.00% 20.00% 8.00%

50/50 Portfolio 5.00% 2.86% 8.00%

Asset Year 1 Year 2 Cumulative

Stocks 20.00% -10.00% 8.00%Bonds -10.00% 20.00% 8.00%

50/50 Portfolio 5.00% 5.00% 10.25%

Note: The composition of the “No Rebalancing” portfolio is 57.1% stocks and 42.9% bonds at the end of year 1.

34

Rebalancing Overview

Why Rebalance?—Investment Policy• During the last five years, rebalancing has

“cost” plan sponsors relative to a “Let Run” policy.

• The strong stock market increased the average equity exposure of a 65%/35% portfolio to 74% during the five years ended 1999.

• The time based and exposure based rebalancing rules resulted in similar results during the last five years.

• The “Let Run” portfolio outperformed both rebalancing rules by 1.6% per year.

• “Let Run” was riskier, but can you “eat” risk adjusted return?

• Why rebalance?

Value of 65%/35% Portfolio

100

150

200

250

300

1995 1996 1997 1998 1999

Wea

lth I

ndex

"Let Run"

Quarterly Rebalancing

5% Proportional Rebalancing

1995 to 1999 Return Risk_Let Run (65%/35%) 22.8% 11.0%Quarterly Rebal. 21.2% 9.4%5% Proportional Rebal. 21.2% 9.3%

35

Rebalancing Overview

Why Rebalance?—Investment Policy• You can “eat” risk-adjusted return when it

comes to rebalancing!• Allowing the equity exposure of the

65%/35% portfolio to increase over time results in a portfolio that averages 74% equity.

• Comparing the “Let Run” with rebalanced portfolios is like comparing portfolios with different equity allocations—and contains the same “information.”

• Rather than letting equity exposure “creep,” it is preferable to adopt a higher equity exposure, and rebalance.

Value of 74%/26% Portfolio

100

150

200

250

300

1995 1996 1997 1998 1999

Wea

lth I

ndex

Let RunQuarterly5% Proportional

1995 to 1999 Return Risk__Let Run (65%/35%) 22.8% 11.0%Quarterly Rebal. 23.1% 10.7%5% Proportional Rebal. 23.2% 10.9%

36

Asset Allocation

Diversification — The Role of Rebalancing• Most mean/variance models assume that assets are rebalanced back to target

levels at some point.

• Without rebalancing, diversification is incomplete.

• Without rebalancing, the addition of non-correlated assets will reduce volatility, but will not enhance returns.

• A clear policy avoids costly ad-hoc revisions.

• If you do not rebalance, the market will do it for you.

• Rebalancing is a vital part of investment policy.

37

Asset Allocation

References

• 1Brinson, Gary P., L Randolph Hood, and Gilbert L. Beebower. 1986. “Determinants of Portfolio Performance.” Financial Analysts Journal, vol. 42, no. 4 (July/August): 39-48.

• 2Brinson, Gary P., L Brian D. Singer, and Gilbert L. Beebower. 1991. “Determinants of Portfolio Performance II: An Update.” Financial Analysts Journal, vol. 47, no. 3 (May/June): 40-48.

• 3Ibbotson, Rodger, Paul D. Kaplan. 2000. “Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance?” Financial Analysts Journal, vol. 56, no. 1 (January/February): 26-33.