In our last newsletter we focused on the importance of choosing a money manager with future outlook in mind. This month we expand on that topic and highlight the importance of diversification, specifically among different asset classes. This may be a topic you have heard about over and over, but that doesn’t diminish the importance of diversification across different asset classes. In fact, we bet that you’ll be surprised with some of the information below and how it can affect the performance of your overall portfolio.
Asset Allocation
We here at WrapManager continue to stress the importance of long-term investing and diversification across the asset class spectrum. This includes large-cap, mid-cap, small-cap, international, emerging markets, fixed income, and others. Over the long-term, exposure to several asset classes may be an important aspect of your overall investment plan. Aside from the old saying to not have all your eggs in one basket, using asset allocation as a risk management tool is a departure from the traditional investor focus on purely performance returns. Over the medium- to short-term, it may be prudent to overweight or underweight your portfolio to certain asset classes, depending on the expected future market outlook. Note that this does not necessarily mean eliminating a specific asset class, but instead increasing or reducing your exposure.
An article in the Financial Analyst journal further supports these ideas after conducting a study of large pension plans. They found that asset allocation accounted for approximately 91% of the investment’s eventual outcome. By comparison, they found that investment selection accounted for 4.6% and market timing accounting for just 2.2%.* It’s important to note that if a certain asset class performs poorly one year, chances are that your manager for that asset class performed poorly as well. The idea being similar to the phrase, a rising tide lifts all ships, with the rising tide being the market and the ships being the various asset classes and individual securities. The manager may have outperformed their peers, but other assets classes may have performed better.
Chasing the ‘Hot’ Asset Class
As we highlighted in our last newsletter, just because a money manager does well one year, does not mean it will do well the next year. The same applies to asset classes. The chart below is a client favorite and highlights the performance of the major asset classes over a long term period. As you can see, there are several instances of an asset class performing well one year and having poor relative performance the next. It is also worth pointing out that there are instances when an asset class performed well over several consecutive years. Take a look at Emerging Market stocks from 2003-2007. It was the best performing asset class in each year, except for 2004, when it was the second best performing asset class.
We can further illustrate the “chasing” by comparing the asset class returns to the fund flows into/out of the asset class for each year. For example, below is a chart of returns for international and emerging market stocks compared to the total flow of money into funds of those asset classes. The chart speaks for itself, but to highlight: in 2007 $139 billion went into emerging markets and international funds. The next year both were down substantially.
We’ve quoted Wayne Gretzky several times in the past, but it is worth repeating (and a favorite here at WrapManager). “I skate to where the puck is going to be, not to where it has been.” The point is to try and be positioned to take advantage of an asset class’s performance before it experiences the run up. Being diversified across asset classes can help achieve this goal.
The Importance of an Unbiased View
It would not be surprising to see a manager actively marketing and promoting the specific asset class(es) in which it specializes. Money managers often offer multiple strategies and several even specialize in specific areas. One manager may offer a mid-cap strategy, small-cap strategy, and international strategy, while another might specialize in just one area with one strategy. They may have good reason to believe a certain asset class will do well, but in the end, that’s their business. A money manager will also never fire itself for underperformance. It’s important to have someone look at your money managers and asset classes with an unbiased view. Doing so can prove invaluable if any asset allocation or money manager adjustments are needed.
Our Wealth Advocates here at WrapManager are ready to take a look at your current financial situation and money managers. We stress the importance of developing and having a financial plan to not only have goals in place, but also put your mind at ease by knowing where you are and where you want to go.
Give us a call at (800) 541-7774 or email at to speak with your Wealth Advocate.
* Source: Brinson, Singer and Beebower, Financial Analyst Journal, May/June 1991. Asset allocation/investment timing cannot eliminate the risk of fluctuating prices and uncertain returns.
Asset Class Definitions Asset Class Blend Return on an equal blend of all indexes. Cash Barclays Capital US Treasury Bills (1-3M) - An index that is representative of money markets. Commodities Dow Jones-UBS Commodity Index - Reflects the return of underlying commodity futures for commodities traded on the U.S. exchanges and London Metal Exchange Emerging Market Stocks MSCI Emerging Markets Index - Designed to measure equity market performance of 22 emerging markets. International Stocks MSCI EAFE - Represents all of the MSCI developed markets outside of North America. Investment-Grade Bonds (1995-1996) Barclays Govt . /Credit Bond Index - Based on all publicly issued intermediate- and long-term government an corporate debt securities. ( 1 9 9 7 - 2 0 0 9 ) Merrill U. S. Government/Corporate Master Index - A statistical composite tracking the performance of the entire U.S. corporate bond market over time. High-Yield Bonds Merrill U.S. High-Yield Constrained (BB-B) - A broad measure of the high-yield fixed-income market that caps the allocation of any one issuer at 2%. Emerging Market Bonds Merrill Emerging Market Sovereigns - Tracks the performance of sovereign debt issued and backed by over 20 emerging market countries. Real Estate Securities MSCI REIT Index - Represents equity real estate investment trusts (REITs ) that generate the majority of their revenue and income from real estate rental and leasing. The index represents approximately 85% of the U.S. REIT universe. Large-Cap Stocks S&P 500 - Covers 500 industrial , utility, transportation and financial companies in the U.S. markets. Mid-Cap Stocks S&P MidCap 400 - The 400 U.S. companies on the S&P Composite 1500 index with market capitalization that is greater than that of companies on the S&P SmallCap 600 and less than that of companies on the S&P 500. Small-Cap Stocks S&P SmallCap 600 - The 600 smallest U.S. companies on the S&P Composite 1500 index as measured by market capitalization. Recessions As defined by the National Bureau of Economic Research.
This chart is provided for illustrative purposes only and is not indicative of any specific investment; individual investment results will vary. Information has been obtained from sources believed to be reliable,but its accuracy is not guaranteed. The data assumes the reinvestment of all income and dividends and does not account for taxes and transaction costs. Investment manager performance relative to the different asset class indexes has varied widely across the asset classes during the past 15 years. Returns for asset classes shown reflect inception of benchmarks used. Asset allocation/investment timing cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance is no guarantee of future results. Please note that all indexes are unmanaged and do not take into account any fees or expenses of investing in the individual securities they track, and that individuals cannot invest directly in an index. Investments in stocks and bonds are subject to risk, including market and interest-rate fluctuations. Stocks of mid-cap and small-cap companies are typically more volatile than stocks of larger companies. They often involve higher risks as they may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions. Global/international investing involves risks not typically associated with U.S. investing, including currency fluctuations, political instability, uncertain economic conditions and different accounting standards.
High-yield bonds, commonly known as junk bonds, are subject to greater risk of loss of principal and interest, including default risk, than higher rated bonds. The prices of these bonds may be volatile, and they are generally only suitable for aggressive investors.
There are special risks associated with an investment in real estate, including credit risk, interest rate fluctuations and the impact of varied economic conditions. Buying commodities allows for a source of diversification for those sophisticated persons who wish to add commodities to their portfolios and who are prepared to assume the risks inherent in the commodities market. Any purchase represents a transaction in a non-income-producing commodity and is highly speculative. Therefore, commodities should not represent a significant portion of an individual’s portfolio..
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