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Reading 25: Asset Allocation-LOS c

CFA Institute Area 3-5, 7, 12, 14-18: Portfolio Management
Session 7: Asset Allocation
Reading 25: Asset Allocation
LOS c: Appraise the importance of asset allocation for portfolio performance.

Empirical studies indicate that the majority of the variability in a portfolios returns and a portfolios long-term performance are each respectively explained by:

Variability in ReturnsPortfolio Long-Term Performance

A)
Tactical Asset Allocation Strategic Asset Allocation
B)
Strategic Asset Allocation Tactical Asset Allocation
C)
Strategic Asset Allocation Strategic Asset Allocation
D)
Tactical Asset Allocation Tactical Asset Allocation


Answer and Explanation

Strategic asset allocation combines long-term capital market expectations, investor risk and return objectives, and constraints to determine target weight to asset classes. A study by Brinson, Hood, and Beebower (1986) found that 94% of the variability of portfolio returns is explained by the portfolios strategic asset allocation. A second study by the Vanguard Group (2003) showed that more than 100% of the long-term performance of a portfolio is explained by its strategic allocation. Based on these studies and others, the importance of strategic asset allocation for portfolio performance is without question.

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Brad Windbigler and Crystal Williams, portfolio managers for Lucite Investment Management, are discussing the importance of asset allocation for portfolio performance. In their conversation, Windbigler makes two statements:

Statement 1:A clearly defined strategic asset allocation provides discipline in ensuring that the investors portfolio accurately reflects the investors desires with respect to risk and return.
Statement 2:Over the long run, asset classes seem to respond somewhat homogenously to systematic risk factors, which means that tactical asset allocation will tend to explain the majority of the variability of portfolio returns.

After listening to Windbiglers statements, Williams should agree with:

A)Statement 2 only.
B)both Statement 1 and Statement 2.
C)
Statement 1 only.
D)neither of the statements.


Answer and Explanation

Williams should agree with Statement 1. Even though investment managers are experts at selecting good investments, investment managers need discipline in the search for reward versus systematic risk. A clearly defined asset allocation provides such discipline by ensuring that the investors portfolio accurately reflects the investors desires with respect to risk and return. Williams should disagree with Statement 2. It is true that over the long run, asset classes do respond somewhat homogenously to systematic (macroeconomic) risk factors, however, this supports the conclusions drawn by empirical studies that strategic asset allocation tends to explain the majority of the variability in portfolio returns. This is because the asset class selected (not necessarily the security or timing) will tend to dictate the response of the portfolio to changes in interest rates or other macro economic factors.

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Professor Erik Rickel, an instructor for Babcock College asked his Investments 340 class to identify reasons that support the conclusion that strategic asset allocation is the most important factor for defining portfolio performance. Three of Rickels students raised their hands and gave answers to his question. The answers given are as follows:

Prickett:   Defining an investors strategic asset allocation helps the portfolio manager focus on the investors goals with respect to risk and return.
  
Rorrer:   Results of academic studies show that the overall returns to market timing and security selecting are minimal at best and in many cases do not cover a portfolios operating expenses and trading costs.
  
Cloe:   Since the assets within asset classes tend to have a similar response to macroeconomic changes, the target weights of the portfolios chosen asset classes will tend to drive the variability of portfolio returns.

Which of the students statements accurately support the conclusion that strategic asset allocation is the most important factor for defining portfolio performance?

A)Pricketts and Cloes only.
B)Rorrers and Cloes only.
C)
Pricketts, Rorrers, and Cloes.
D)Cloes only.


Answer and Explanation

All three of the students statements are accurate and all three support the conclusion that strategic asset allocation is the most important factor for defining portfolio performance. A clearly defined asset allocation provides discipline and focus on an investors goals by ensuring that the investors portfolio accurately reflects the investors desires with respect to risk and return. Also, empirical studies support the conclusion that strategic asset allocation (not timing or security selection) defines the vast majority of a portfolios long term performance, and the variability of portfolio returns.

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