The Asset Allocation Model And Pension Value Investing

Christopher M. Quigley B.Sc., M.M.I.I., M.A. www.wealthbuilder.ie

Academic Background In 1986, Gary Brinson L. Randolph Hood, and Gilbert L. Beebower (BHB) published a study about asset allocation of 91 large pension funds measured from 1974 to 1983. They replaced the pension funds' stock, bond, and cash selections with corresponding market indexes. The indexed quarterly returns were found to be higher than pension plan's actual quarterly return. The two quarterly return series' linear correlation was measured at 96.7%, with shared variance of 93.6%. A 1991 follow-up study by Brinson, Singer, and Beebower measured a variance of 91.5%. The conclusion of the study was that replacing active choices with simple asset classes worked just as well as, if not even better than, professional pension managers. Also, a small number of asset classes were sufficient for financial planning. Financial advisors often pointed to this study to support the idea that asset allocation is more important than all other concerns, which the BHB study lumped together as "market timing One problem with the Brinson study was that the cost factor in the two return series was not clearly discussed. However, in response to a letter to the editor, Hood noted that the returns series were gross of management fees. With the development of Exchange Traded Funds (ETFs) it has never been easier to embrace the concept of Asset Allocation Investing. These ETFs cover stocks, commodities, bonds, currencies, real estate et al. As the BHB study above indicate an active managed pension fund that chooses individual stocks and bonds does not necessarily mean a more profitable portfolio. The use of indices or ETFs as investment vehicles however does remove a great deal of the risk associated with raw equity, real estate, commodity or bond ownership. The Value Approach I am an enthusiastic value investor. I like the concept and it has proven its profitability over the last decade that I have been active in the markets. I believe bringing the techniques of value portfolio management to asset allocation investing is very exciting. Such a strategy blends conservative diversification, with dollar cost averaging (saving in normal parlance) and technical analysis of long term asset class prices. How does it work in simple terms? For example let us have our investor choose say 3 asset classes for his/her portfolio: Stocks (An ETF of The S & P 500), Real Estate (An ETF of top Real Estate Players) and Gold (An ETF of the commodity). The idea now is to bring into the equation some technical assessment of long term value. Each of our classes will have a different value determinant, as set out below:

Stocks: PE Ratios Real Estate: Rental Income Multiples Gold: Inflation Trend Index of Price With each type of asset we will use in our analysis a long term graph indicating our indicators technical/historic trend. Those asset types currently priced significantly beneath the long term asset-class-average would be regarded as undervalued and those assets priced significantly above the long term asset-class-average would be viewed as overvalued. Now with a pension portfolio we need to obviously have diversification among several asset types but the key to achieving above average returns involves a little more effort. The smart thing to do is invest a disproportionate amount into the class that is undervalued and discharge those classes that are overvalued, in a systematic manner. Remember we will be looking at these shifts in allocation emphasis happening over years not days, weeks or months. Ideally the portfolio should be saved into over a long period of time. Such an approach removes the potential for capital loss through trying to time the market on entry. This approach is continued as long as the fund is active. As the portfolio term reaches maturity all classes are systematically sold and shifted into cash starting with those most overvalued. This policy prevents the fund from receiving value shock just when liquidity is most needed. It is interesting to note that some of the worlds best managed endowment funds (such as the Harvard Endowment Fund) use the asset allocation approach to investing It has proven spectacularly successful and is one of the reasons more pension funds are choosing this simple self-managed approach rather than sub-contracting their decision making out to conventional equity specialist. The dreadful returns achieved from passive equity investment since 2000 has hastened the trend as has the fabulous returns earned through commodity and bond investment over the last three-five years. Reference: Wikipedia

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