It is important to recognise that asset allocation is inherently a two-stage process. The first step should be to formulate a benchmark position, based on weighing the investor’s return desires against their tolerance for risk, be it in absolute terms or relative to a liability ‘benchmark’.
Once the investment policy or benchmark for the fund is determined, active asset allocation aims to capitalise on temporary deviations from normal capital market conditions. At times, investors will become too optimistic, bidding up the prices of certain assets well above their intrinsic value. The opposite can also occur when gloom and pessimism prevail. By shifting the portfolio’s exposures out of unattractively priced assets and into those priced relatively more in line with fundamentals, active asset allocation can help protect capital or add value over time.
Years ago, assets tended to be viewed more in an isolated fashion rather than as elements in a broader portfolio. In fact, a fiduciary responsible for managing the pool of capital could be faulted for holding a security that turned out to be ‘too risky’ or inappropriate for the ultimate beneficiary of the portfolio. Notions such as ‘don’t invade principal’ were common, as were policies such as holding bonds for cash flow needs. Management of funds on a total return basis was consequently not the standard approach.
With the growth of modern portfolio theory, pathbreaking organisations such as the Ford Foundation led the way toward a more comprehensive view of portfolio management. Fiduciaries and plan sponsors began moving in the direction of managing for total return, weighed against the risk posture of the portfolio as a whole. Assets that may be very risky on a stand-alone basis now could be prudently included in a portfolio because they have a much smaller impact on overall risk.
As these ideas became more widely accepted, ‘risky’ assets such as equities were introduced to portfolios that previously were predominantly invested in fixed income securities. From the 1950s through the 1970s, portfolios came to include much greater allocations to such assets. Subsequently, allocations both across asset classes and through decreased concentration in investors’ home markets led to greater diversification from the 1980s onward.
US pension funds at the start of the 1980s held well under 50% of their assets in equities, with a relatively large portion of assets in balanced mandates and almost nothing held in non-US securities. Because the markets were just emerging from the terrible experience of the 1970s – dismal returns and increasing inflation – asset allocation during this period was generally focused on absolute risk and protecting capital from further damage.
As we moved through the 1980s, and despite the (temporary) setback in equities in October 1987, returns to both stocks and bonds were very good. The pendulum started to swing toward relative risk; managers’ objectives were increasingly set relative to specific, even narrow, asset-class benchmarks. Global investing started to emerge as a way to diversify portfolio risks without giving up long-run return potential. By the end of the decade, equity share rose above 50%.
These trends continued into the 1990s, with equities constituting about 60% of pension assets and the non-US allocation approaching 15% – still not a huge amount, but significant nonetheless. One restraint to further shifts outside the domestic markets was the notion that, since returns were so good in the US, there was no justification for investing elsewhere. Overall, the two-decade trend has been toward greater allocations to riskier assets, with the increased diversification dampening the risk.
In most other institutional marketplaces outside the US, the story was much the same during the 1990s. However, data limitations preclude concrete conclusions for earlier periods. In Japan, Australia and Europe (apart from the UK), equity allocations increased at the expense of cash and fixed income. In addition, there was rapid growth in non-domestic investment, albeit from very low initial levels. Chart 1 shows the equity allocations, both domestic and international, in some select markets over the past ten years.
Two steps forward…
What can we learn from this progress? All the signs are quite good that practice has been catching up with what academia has been telling us for more than four decades. Investors have indeed taken into consideration the lessons of now-conventional portfolio theory. Levels of diversification have increased; home bias, and thus uncompensated risk concentration, has fallen. It is not, however, undeniably clear that the lessons are fully ingrained in investor thinking. The increases in equity allocations, for instance, may have simply been a response to good stock market performance – sticking with, or even buying more of, a ‘winner’.
There was continued talk by many in the US in the latter half of the 1990s that investing outside of the domestic markets was useless, as the dollar strengthened and domestic equities were superior performers. Lost in the analysis was the fact that diversification does not imply that one’s portfolio of assets will always (or ever) outperform the best performing of the components. This reticence to invest abroad continues even now.
Likewise, asset allocation principles are often abandoned when fear or greed come to the fore. Investors have a tendency to exhibit counterproductive ‘buy high, sell low’ behaviour when markets move substantially out of line with prior experience and expectations. The increased allocations to equities in the 1980s and 1990s, again, could be partially a result of investors responding to good equity market performance.
More recently, venture capital drew massive amounts of new investors, both in the US and elsewhere. Record commitments of capital coincided with the peak in the equity market bubble (see Chart 2); these were fueled in part by fears of ‘missing out’ on the stratospheric (but unsustainable) returns. Venture capitalists’ behavior became egregious as well, with fee levels and fund terms in some cases becoming rapacious simply because venture capitalists could command those feel levels for ‘access’.
Currently, with equity returns poor and fixed income yields low, for institutions (and individuals) looking for downside protection and ‘absolute’ returns, hedge fund investments have become the plat du jour. It is interesting to note that these days much of the hedge fund money is invested in hedged strategies, particularly long-short equity. This is a striking contrast with the prominence of macro funds, with their greater risk and large net long exposure, in the 1990s’ environment of strong equity and currency returns.
These stories are nothing new; only the particulars change from one episode to another. What they have in common is a tendency for investors to chase performance or ‘safety’, which usually occurs at the expense of achieving longer-term objectives.
Staying the course
Remedying this situation requires nothing more than following the principles of asset allocation. The first is to set a benchmark policy based on consistent long-term risk and return assumptions. Market movements should not in general produce adjustments in the fundamental assumptions. In our flagship balanced portfolios, such as the Global Securities Portfolio, the benchmarks are diversified globally and across numerous asset classes. Such a policy provides the ‘anchor’ for the portfolio, protecting against performance-chasing behaviours.
Active investment decisions then take into account that experiencing returns well above expectations usually forewarns of lower – not higher – future returns, in the absence of changes to the underlying fundamentals. Exposures to assets with too-strong price gains would, as a result, be reduced. Additionally, rebalancing regularly to the desired asset class weights forces the investor to buy those assets that have become cheaper and to sell those that have become relatively expensive.
Having established that asset allocation is important, and recognising that investors are prone to wavering confidence during difficult times, we think that there are a number of issues worth pointing out about the potential future direction of asset allocation.
First is the likelihood of further reductions in home bias in the equity components of portfolios. Where there are no binding legal constraints, it continues to make sense for investors to reduce or eliminate home bias. The improvement in diversification alleviates industry and single-stock concentrations that often occur in home-biased portfolios. For example, the Swiss market is quite skewed to pharmaceutical and financial firms. Oftentimes, these problems solve themselves with adverse consequences for investors. One only has to think of Nortel in Canada, Ericsson in Sweden or Oracle (and technology companies more generally) in the US.
Another area that must be addressed is pension funding strategy. In a low-yield fixed income environment, an avoidance of riskier assets almost assures that a plan sponsor will need to increase plan contributions to meet its obligations. In addition, the trend toward placing the investment risk burden on beneficiaries may accelerate. Companies would continue to shift away from defined benefit and toward defined contribution plans; and foundation and endowment grant recipients could see reductions and increased volatility in their cash flows.
Further, with the troubling environment experiences in the last two and a half years, we could likely see an increased focus on risk assessment and better thinking about the long-term return expectations in various asset classes. It is clear that some investors have put too little consideration into their risk tolerance, and were not prepared for the lower half of the distribution of outcomes. Is it too much to hope for that investors will engage in serious thought about capital market fundamentals rather than extrapolating the past, as they are wont to do?
It is important to recognise that asset allocation does indeed work when done properly. The normal benchmark position provides an anchor for the portfolio, helping to smooth the often violent fluctuations in returns in individual asset classes. Increasing the efficiency of the policy by adding new asset classes and reducing biases will also help achieve long-term return objectives without assuming undue risk.
Active management of the allocations can add value by improving risk-adjusted returns – reducing exposure to “too hot” assets forestalls the herd behavior of chasing performance and experiencing the bursting of bubbles.
Ultimately, what we would like to see would be explicit incorporation of the concepts of portfolio theory that have been around for over 40 years into the construction of proper investment policies.
Kevin Terhaar, CFA is head of asset allocation strategy and analysis at UBS Global Asset Management in Chicago

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