The asset allocation lie

By Tom Bulford Oct 18, 2012

Tom Bulford

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In last week’s MoneyWeek magazine, Merryn Somerset-Webb interviewed Alan Miller, a successful fund manager. In the interview Merryn remarked that "endless studies show that it is asset allocation that makes the difference to most portfolios".

Miller makes no attempt to differentiate a good share from a bad one, but simply makes decisions between ‘asset classes’. In other words, he will commit his clients’ money, in certain proportions, to UK bonds, overseas bonds, US equities, emerging markets and UK small companies, etc. He will try to add value by altering the proportions held in each asset class without making any attempt to add value within them by, for instance, selecting good shares over bad ones.

Today, I will show you why I think this notion is self-serving nonsense. It is simply a conceit put about by the big fund managers and is entirely detrimental to the efforts of private investors.

How can I say so when Merryn’s "endless studies" have shown otherwise?

What happens when you split two asset classes?

Let me simplify the matter.

Suppose a big fund manager splits his portfolio between two asset classes, Japanese equities and US equities. Let’s also say that, as most fund managers do, he has a very large number of individual shareholdings – I’ll say 100 in each market. What the proponents of asset allocation will tell you is that, instead of worrying about each individual share, you should worry about whether the Japanese market will outperform the US market or vice versa.

Now, suppose that the US market rises by 10% and the Japanese market falls by 10%. And there is a further 10% appreciation of the dollar against the yen. That gives a 30% outperformance of the US equity market versus Japan. The smart fund manager will have been ‘overweight’ in US equities, and however well his Japanese shares may have done relative to the Tokyo index it is inconceivable that they could have made up for this 30% market swing.

Fair enough. But the reason that stock selection cannot make up the difference is that the fund manager holds so many shares. Furthermore these are probably representative of the index and move in line with it.


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Why would you want to own 200 shares?

So now suppose that instead of holding 100 US shares and 100 Japanese shares our fund manager holds just two in each market. Then it becomes entirely possible that he might, by picking great Japanese companies, make more from his Japanese shares than his US shares, regardless of how the indices move.

Fund managers love to talk about the importance of asset allocation because it plays to their perceived strengths. They employ economists and strategists, who are able to keep track of the global economy in a way that we individually cannot. So it suits them to tell us we need to be investing globally, even though there is really no need at all. Next they like to claim that, from their lofty intellectual vantage point, they are rather good at predicting the path of the global economy and the world’s financial markets, even though I have never seen any evidence that this is so.

What’s really wrong with asset allocation?

But the main reason they peddle the asset allocation line is that, due to the huge amount of money they manage, they have no option but to hold vast numbers of individual shares. The impact of any one share, however good or bad, is going to be so insignificant that it can never offset index swings that affect maybe 20%-30% of the portfolio simultaneously.

There are two more reasons why the asset allocation argument is disingenuous. First of all, a share index only consists of its underlying corporate constituents. So assessing the companies individually on a ‘bottom-up’ basis should lead you to the same conclusion as the ‘lump them altogether into one’ top-down asset allocation approach. 

Finally, be under no illusion that asset allocation is just gambling by another name. For every fund manager who goes long of Japanese equities, another is going short. Some will get it right for a while, but others will get it wrong and in aggregate all they will do is swap assets while of course charging their clients for this activity.

Asset allocation is a game played by fund managers because they know no other. But we private investors have no need and should not act like this.

We can afford to be very selective, to pick only shares in great companies and ignore everything else. This, by the way, is much, much easier than attempting to predict global markets. And maybe it explains why the world’s most successful investor is an old-fashioned stock picker from Omaha, Nebraska.

• This article is taken from Tom Bulford's free twice-weekly small-cap investment email The Penny Sleuth. Sign up to The Penny Sleuth here.

Information in Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd.

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  • 1. AW

    (18 October 2012, 11:27PM)  Complain about this comment

    The example you give is NOT asset allocation but purely geographical spread. Asset allocation involves investing in various asset classes - cash, fixed interest, equities and commercial property. Within equities the breakdown may well be between UK, International and emerging markets. It may be small, mid or large cap, growth or income.

    There was I thinking Money Week preferred index tracking passives rather than stockpickers. Or is it simply that yet again there is another fantastic wheeze that you and others are trying to sell us? Merryn gave a portfolio a few weeks back that was nothing more than favoured stocks and lacked any real thought or processs.

    I like much of what Money Week says but to continually bash the investment industry, IFA's, OEICS an UT's is maddening and self-serving. Perhaps every 3 months there should be a tally of winners and losers from Money Week tips to see how good they really are and at what level of risk!

  • 2. Surjadi

    (19 October 2012, 12:03AM)  Complain about this comment

    Japanese equity and us equity are consider one class of asset which is equity. Asset allocation meaning you invest your wealth in various kind of assets like cash (currencies), bond, equity, gold, property, arts, etc. you try to have uncorrelated asset in your portfolio so they would become balance.
    Japanese equity and us equity are not asset allocation since they are still consider one asset class which is equity.

  • 3. Dyadco

    (19 October 2012, 10:45AM)  Complain about this comment

    Both AW and Surjadi are correct.

    "Asset allocation" as Tom has described is very different to what is commonly understood as being "asset allocation".

    As an aside, I really wish that Money Week would just concentrate on producing ONE fine magazine without trying to on sell us into numerous other publications.

  • 4. Steve

    (19 October 2012, 11:42AM)  Complain about this comment

    I have no background in finance or business but realised the importance of Asset Allocation about three years ago. Frankly, this article is a little scary. In my opinion, Asset Allocation doesn't get nearly enough attention. Having your investments spread among equity, property (REITS etc), bonds (+PIBS and pref shares) and PMs, here and abroad, emerging markets etc provides less volatility and lets me sleep easier at night.
    Steve

  • 5. Oliver W

    (19 October 2012, 01:47PM)  Complain about this comment

    Tom is actually right regarding his example of asset allocation; it's just that the phrase 'asset allocation' can be used in different ways. You could, for example, say asset allocation within UK equities, i.e. did you invest in the correct sectors (financial companies/consumer goods companies etc). The term Asset Allocation (at least within the financial industry) doesn't necessarily mean allocation between the different asset classes.

  • 6. LERENARD

    (19 October 2012, 01:59PM)  Complain about this comment

    The interests of the fund managers and their investors do not necessarily align: Investors are always better off managing their own portfolios provided they get a decent education. Asset allocation is the classic risk diversification strategy i.e if we get it wrong in a few asset classes, the winners will make up for the losers. A better approach is the vertical rotational method where you rotate in and out of performing and non performing assets. This is actaully easier to do than it appears using simple technical and fundamental analysis. That is what the smart money does !

  • 7. James

    (19 October 2012, 03:31PM)  Complain about this comment

    The encouragement to just pick a few shares that you 'really understand' in 'good quality' companies is madness and come under gambling in my book. Good companies do blow up e.g BP, Tesco recently, the banks. Regardless of whether you can hold on for recovery, the feeling of being sat on 20% / 40% / 80% losses isn't great. But then again, the readers have no come back on Moneyweek - Tom doesnt have to take any responsibility etc.

    For the vast majority of people, funds (either passive or active) or investment trusts are the most appropriate way to build assets up. Have a dabble on small companies if you like but make sure it's from your 'gambling funds' which you are prepared to lose.

    What is dangerous is that an article like this is soon followed by a tip for a Bahamas Oil exploration company or a tech-start up. How many people decide to give up on their steadier (boring) funds in favour of these opportunities? Quick way to wreck one's retirement planning in my opinion.

  • 8. Stephen Lowe

    (19 October 2012, 04:45PM)  Complain about this comment

    Tom's view is misguided and James (7) is right. But note that asset allocation isn't necessarily tactical timing based on supposed superior foresight: it usually involves rebalancing by topslicing outperforming assets and rotating into underperformers. But I do sympathise with tom's frustration: there IS WAY too much diversification and it IS in the interests of most institutiona managers to overcomplicate things, partly for liquidity reasons and partly to manage their career risk. Ten very different holdings in which you really believe and have a good understanding, seasoned by long familiarity, are probably enough to produce superior performance, provided that you cut the losers (less need to cut the winners, imo).

  • 9. Steve

    (19 October 2012, 10:11PM)  Complain about this comment

    Hi Stephen,
    As far as I understand Asset Allocation, 'rebalancing' is in itself a whole other subject and depends on many factors such as whether you're just starting out, age, cost of trading relative to total holdings value, the % increase/decrease at which you rebalance etc.
    When you say Way too much diversification, are you talking about the diversification 'available' to private investors, or about funds and ITs in general? As a smallish private investor, the diversification now available via ETFs have been a godsend.
    Steve

  • 10. Carl J

    (20 October 2012, 02:02PM)  Complain about this comment

    I don't agree with the article's assertion that "there is really no need at all [to invest globally]". There is a vital need, and that is to flee the sinking ship called the GBP. Let's suppose that, through careful selection of UK small caps, you have grown your portfolio by 50% since 2007. That sounds pretty good, and the government will certainly point to it as a substantial capital gain and take a big chunk of it in tax. But, measured in one of the many currencies against which the pound has been hammered (e.g. the Aussie dollar), you have actually lost money.

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