Asset Allocation Process

A Summary of the Five-Step Process

  1. Establish a neutral allocation for each portfolio type.
  2. Shift our asset allocation away from neutral based on asset classes that undervalued relative to competing asset classes.
  3. Look for “fat pitch” opportunities — situations in which we can make high-confidence assessments of the impact of cyclical factors that create extremely undervalued areas of the market.
  4. Make tactical asset allocation decisions based typically on an eighteen to thirty-six month time horizon.
  5. Analyze and choose actively managed mutual funds, and in some cases passive index funds, to implement our asset allocation.

Step One: A Neutral Allocation

What is a neutral allocation?

It reflects a sensible, static, strategic asset allocation for a hypothetical long-term investor who is not using tactical asset allocation. It is the starting point for our tactical asset allocation process.

What is the purpose of the neutral allocation?

  1. The neutral allocation is the asset allocation that we will fall back to when our conviction level about any specific asset class is not high enough to justify changing the asset allocation mix. It gives us a baseline long-term allocation that is based on thorough research and historical experience.
  2. It gives us a constant frame of reference against which to measure each decision. For example, if we like REITs, we must decide what they will replace in the portfolio and how far from neutral we are willing to move. This will be a function of our confidence and the impact on the portfolio’s risk and return potential. The permanent frame of reference imposed by the neutral allocation assures that we will consistently apply our methodology. It is this discipline that is so valuable. Consistent application of a discipline is critically important to investment success.
  3. The neutral allocation also gives us a benchmark to measure our value added.

How did we arrive at the neutral allocations for each portfolio type?

First we identified risk tolerances, defined as a maximum loss over a one-year period. Then we looked at many different combinations of asset classes over many historical periods. Through numerous iterations of adjusting the asset class mix, and looking at the results over various historical periods (over 80 years) that reflected differing circumstances, we came up with neutral allocations that:

  1. Have very high statistical probabilities of not violating the stated risk tolerance for each model. (Though the probabilities are in the high 90% range, they are not 100% – there is no guarantee that risk levels will not be exceeded going forward.)
  2. Are diversified enough to provide some smoothing of performance.
  3. Have delivered, over the average 10-year period, a higher return than a simple S&P 500/bond mix with slightly less variability. (In the case of equity portfolios, a higher return with less variation than the S&P 500.)
  4. Make sense given what we know about the investment climate today.

How did we choose which asset classes to include in the neutral allocation?

We considered a variety of asset classes. However, we decided to stick to mature asset classes for which we have good historical data. Our neutral allocation consists of the following asset classes as represented by these indices:

  • Investment Grade bonds – Barclays Aggregate Bond Index
  • Large-cap U.S. stocks – S&P 500 Index
  • Small-cap U.S. stocks – Russell 2000 Index
  • Foreign stocks – Morgan Stanley Europe, Australasia, Far East (MSCI EAFE) Index
  • Alternative Investments – HFR Global Hedge Index

Step Two: Tactical Asset Allocation

Our tactical asset allocation process (decisions to diverge from neutral), involves making slight asset class moves (overweighting and underweighting) based on asset classes that are undervalued or overvalued relative to competing asset classes and the neutral allocation. We do so only when we have a very high degree of confidence that the moves will pay off in the long-term.

Step Three: Active Management–Swing Only at Fat Pitches

While slight changes to the neutral allocation are made based on simple relative value differences, larger moves require a high level of conviction. Using a baseball analogy, we only want to swing at “fat pitches” (i.e. pitches that are over the center of the plate that we are likely to hit).

What is a fat pitch?

Financial markets are quite efficient—most assets are priced fairly (based on all publicly available information) most of the time. This means that most of the time it is difficult to “out-smart” the market. However, the market does, occasionally, offer investors exceptional opportunities. Capturing a portion of the return from these opportunities, and locking them in for a full market cycle, can result in market-beating performance over a cycle.

Warren Buffett puts it well when he refers to the manic/depressive nature of “Mr. Market.” Despite all the information that investors have at their fingertips, irrational greed and fear occasionally drive the market for financial assets. It isn’t the norm, but it happens.

Why swing ONLY at fat pitches?

Swinging only at fat pitches is not the only way to invest successfully. However, too many investment professionals believe that investment success requires lots of activity. This is wrong.

Our methodology only allows us to “swing” when we have very strong indications that the odds are heavily in our favor because the market is not pricing rationally – a fairly rare occurrence for asset classes. This may mean little activity in some years. Importantly, by only swinging at fat pitches (and patiently waiting for them), we minimize mistakes by not making large shifts when the financial markets are not giving us a fat-pitch opportunity—not swinging when Mr. Market is neither manic nor depressive. So, only when the markets are clearly acting irrationally will we take action. When they are rational we won’t try to make something out of nothing. It only takes a few fat-pitches over a market cycle to make a difference. But it takes discipline and focus to have the patience to wait for the opportunity, and intestinal fortitude to act when the markets are irrational. Successfully executing a fat-pitch strategy will add value to long-term performance relative to the neutral allocation (a successful long-term investment strategy in its own right).

How do we know a fat pitch?

First, we believe it is critical to apply a consistent approach to identifying fat-pitches. This is part of our discipline. Our research suggests two important factors:

  1. An extreme undervaluation (or overvaluation) relative to alternative asset classes. In measuring this undervaluation, we first compare equity assets (foreign stock opportunities, small companies, REITs) to the S&P 500. In comparing the portfolio’s total equity exposure, we then compare valuations to investment grade bond yields.
  2. The stage of the “risk cycle” can enhance or detract from the valuation argument. Our research strongly suggests that extreme undervaluation in a particular asset class indicates a material period of outperformance is in store in the not too distant future. Many factors may cause the asset class to appear moderately undervalued when it is not. The fat pitches we will swing at will probably be the result of a bear market or a severe correction. This is when the depressive side of Mr. Market shows his face, often in the form of panic selling, causing extreme undervaluation.

Of secondary importance is the stage of the economic/market cycle. If we believe we are beginning a new market cycle (or very close to it) anticipating an economic recovery, this enhances the valuation-driven fat pitch. Not only would this produce great valuations, but also an expected end to the fear-driven psychology that created the undervaluation. On the other hand, if we are late in the cycle but not at the end of it, investors may continue to be cautious, avoiding the more risky assets that usually get beaten up in bear markets (economically sensitive assets and less liquid assets – e.g. small-caps and REITs). This makes the fat pitch slightly less fat, but may not invalidate it totally. Most of the time severe undervaluation coincides with a cyclical bear market when both factors are working together.

It is helpful to think of the market cycle as a risk cycle. As markets move past their early and midcycle strength, investors tend to temper their enthusiasm for more risky equity assets, though the enthusiasm for equities in general remains high, even growing. This leads investors to avoid less liquid or potentially more volatile asset classes. In an economic downturn, after markets have taken the cyclical hit, investors begin to anticipate a recovery, and there is less of an inclination to avoid these more risky assets because of the expectation that the next downturn is a long ways off. Thus, a new risk cycle begins.

One problem is that investors may not know for sure whether a bear market marks the end of an economic cycle until after a rebound has occurred. Our discipline, which focuses on extreme undervaluation, will typically prompt us to take a slightly overweighted position in an asset class before this occurs. We would then increase exposure as we become more confident that a cycle is ending—even if valuations are not quite as good (though they would still be excellent). If we don’t get to this point, we would not add to the position and would unwind it at a lower relative valuation than if we knew we were early in the cycle.

How can we be confident there will be fat pitches in the future?

Our high confidence that there will be fat-pitches rests on the observation that fear and greed have always moved markets. When fear turns into panic, investors truncate their time horizons. They don’t care about three years, or perhaps even six months. This reaction can create tremendous values for those with a discipline that allows them to maintain reasonable time horizons. A strong discipline, consistently applied, can give us the strength to act when others allow fear to cloud their decision-making. It will be especially important to avoid swinging at bad pitches as we wait for opportunities.

Isn’t this akin to market timing?

No. Valuation doesn’t tell us any thing about timing. We expect this discipline to lead us to overweight early (before a bottom) and get us back to or below our neutral allocation before a top. But we have no expectations for stop-on-a-dime market timing. In fact, our discipline is more likely to lead us to reduce exposure far before a market peak than close to a peak.

When there is a fat pitch, how much will we buy or sell?

This will depend on the portfolio. The more aggressive the portfolio, the wider our discretion to over or underweight each asset class. We’re also biased toward capital preservation in our more conservative portfolios and maximizing return in our more aggressive portfolios. The allocations will also depend on whether we believe we are early in cycle, in addition to an extreme valuation opportunity.

How do we take advantage of fat pitches?

In certain equity asset classes we will, at times, use index funds to overweight asset classes (relative to the neutral allocation). Our reasoning is that our research will focus on the opportunity with respect to the asset class, so we want to ensure that we capture the future performance of that asset class. Over short and intermediate periods, there is risk that a manager may be out of sync with the asset class—especially managers who run concentrated portfolios. (In general, we do have a bias towards these types of managers.) Using an index fund eliminates this risk. When we use actively managed funds to implement an overweighting, they will be well-diversified funds that we expect will closely track the index. We will also consider tax-efficiency for taxable portfolios. (Though index funds have the reputation of being tax-efficient, this depends on the index. Small cap index funds have not been very tax efficient.)

When will we use active managers?

For some asset classes, there are no index funds. For others, active managers have been so dominant that it is harder to justify using the index. There are other asset classes for which we’ll have to consider specific factors, such as the Japanese weighting in some international index funds (though it is much smaller than it used to be).

In most cases we will use active managers for long-term positions that form the permanent core of our neutral allocations (for more, see step five below). We do extensive due diligence on managers, and only use those managers in whom we have a very high level of confidence in their ability to continue to outperform a benchmark.

What about taxes?

For taxable accounts, our process is fairly tax efficient because:

  1. It is our intention to hold core positions for very long periods. Thus, they will form a stable portion of the portfolio.
  2. By only swinging at fat pitches, trading activity should be fairly low.
  3. By definition, fat pitch opportunities should be so compelling that the return potential should more than compensate for the tax cost of the round-trip transaction.

Step Four: Make Decisions on At Least an Eighteen-Month Time Horizon

Why 18 months?

Having a long-term perspective is important because it allows us to invest based on fundamental factors such as market valuations which research has shown is important to long-term investment success. The reason we have chosen 18-36 months as our benchmark is that we believe nobody can effectively see much further than 36 months into the future on an economic event. Additionally, an 18-month period is long enough to take advantage of mispriced investments, which is what investing based on market valuations and fundamentals is all about. But just because something is mispriced does not mean that it’s immediately going to payoff. As mentioned earlier, valuations have nothing to do with timing, but we do believe this period is usually long enough for an investment thesis to play out.

Step Five: Analyzing and Choosing Active Managers

Why do we use active Managers?

When it comes down to deciding how we want money managers to actually pick the individual stocks and bonds that make up our portfolios, we believe that it matters what companies earn, what their balance sheet looks like, and how their price compares to historically relevant valuation metrics. This method of security valuation is commonly referred to as fundamental analysis. However, because the vast majority of indexes are constructed based simply on the relative market sizes of companies, by definition they often buy more of the most highly-valued stocks in the marketplace, and less of the lower-valued stock. Investment fundamentals do not get factored into their equation. Therefore, since we want to focus on owning investments that are fundamentally better than other investments, that leads us to active management the majority of the time.  In recent years there certainly have been new strategies developed (for example, by Rob Arnott with Research Affiliates) that take a systematic, rules-based approach to identifying fundamentally sound companies, and we do believe that some of these strategies also have value.  The important point to note here is that if we thought traditional passive index strategies would get us the best long-term return, we absolutely would embrace them.  At the end of the day, we want to embrace whatever strategies are going to help our clients reach their goals, and the vast majority of the time we believe active management will provide the best long-term result.

Final Comments

Making asset class valuation assessments, analyzing risks, and researching fund managers are our core strengths. Our tactical asset allocation, fat pitch approach, and fund selection capabilities represent our primary edge in continuing to seek above-average risk-adjusted returns.

“Even the intelligent investor is likely to need considerable willpower to keep from following the crowd.”
– Benjamin Graham

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