What is asset allocation?

Asset allocation is the process of setting asset proportions in an investment portfolio in order to properly balance risk and reward for a given investor. Put simply, an asset allocator tells an investor how much to invest in each asset class.

To properly perform asset allocation for their clients, practitioners need two types of information.
  1. A client's financial profile. Clients with more risk-aversion and shorter time horizons need to hold safer, lower-return assets compared to clients with more risk-tolerance and longer time horizons.
  2. Risk and return projections for each asset class. Asset allocators use these estimates to choose the investments that will maximize a client's return given their risk budget. If the asset class risk and return estimates are wrong, clients could end up with poor returns or too much risk, jeopardizing their goals.

All asset allocators think carefully about the first question. We think the second question is just as important.

Static allocators don't change with financial conditions.

Given a client's financial profile, a static allocator will always recommend the same investment proportions. They assume that asset classes will have the same risk and return in the future as they did in the past.

Static allocators would have told their clients to invest just as much in stocks in 1990 as in 2000. During the 1990s, that worked out well for investors, as the S&P 500 experienced a phenomenal total return of 431%. Yet during the following decade, the S&P 500 proceeded to lose 9%, including an interim drawdown of over 55%.1 Those who invested in 2000 did not get the returns they expected, and their wealth suffered greatly as a result.

We think static allocators do their clients a disservice by telling them that the future will always look like the past. Financial conditions change rapidly, and likely future returns do as well.

Is there a better way to approach this problem than to naively assume that future returns will equal historical returns?

Dynamic allocators adapt.

Dynamic allocators change their investment recommendations as financial conditions change. They examine historical tendencies, try to understand economic relationships, and construct models. This can allow them to make reasonable projections for the future, rather than assuming it will be an exact replica of the past.

These projections, and the portfolio changes they imply, are vitally important to returns. A 2010 Morningstar study estimated that roughly half of portfolio return variances were determined by asset allocation decisions. 

At Bireme, we believe strongly in dynamic allocation, and we estimate future returns using proprietary quantitative models. Using these projections, we can allocate based on the opportunity set available instead of trailing returns. We try to put our clients in the right assets at the right time, so they get the risk and and return they expect.

Our approach.

Talk with you.

We spend time understanding your unique situation, including investment philosophy, risk tolerance, and time horizon.

Set bands.

We work with you to set allocation bands for each strategy. For example, between 10% and 30% in our bond strategy. We revisit these bands periodically.

Allocate.

Bireme allocates your funds to our different strategies based on our estimated returns, within the bands set by you.

Monitor and rebalance.

We actively monitor estimated returns. As conditions change, we move your funds between strategies within your unique bands.

Outperformance requires a long-term mindset.

No one, including us, can predict with any certainty the performance of asset classes over the next year. But over longer time horizons, returns to asset classes are surprisingly predictable.

These charts2 illustrate the point. The graphs compare the total return predictability of the S&P 500 over the long term and the short term.

The red line in both charts is the cyclically adjusted price-to-earnings ratio (CAPE), a simple and well-known equity valuation tool.3 The CAPE is an extension of the common price-to-earnings ratio, using average real earnings over the past ten years to smooth out fluctuations in the business cycle. The CAPE is inverted as high CAPE values (high stock prices relative to underlying earnings) presage lower future returns.

We can compare the CAPE to the future total return of the S&P 500. In the top chart, the blue line shows the return over the next ten years; in the bottom chart, the blue line shows the return over the next one year.

The CAPE closely tracks the long-term, 10-year future return in the top chart. Therefore, we can predict with some certainty the performance of stocks over the long-term. However, the bottom chart shows a different picture: the CAPE tells us very little about next year's returns.

​Future returns to asset classes, though mostly random over short horizons, show significant predictabilility over long horizons, even using relatively simple and well-known tools like the CAPE. This predictability may enable dynamic allocators to outperform. At Bireme, we hope to use our long-term focus and sophisticated analysis to deliver great results to our clients by investing in the right assets at the right times.

Reverse the behavioral return gap.

To successfully take advantage of the long-term relationship between asset class valuations and returns, investor time horizons must be similarly long-term. Instead, many people focus on short-term returns when making their investment decisions. For example, academic research shows that short-term fund performance drives a substantial portion of mutual fund flows.

Unfortunately, this performance-chasing costs investors dearly, resulting in underperformance relative to the buy-and-hold return of the funds they are invested in.

​Chasing fund performance is often the quickest way to hurt [returns].

For the overall mutual fund universe, this underperformance amounts to 1.94% annually.4 Investors in passive index funds tend to do even worse, underperforming buy-and-hold by -2.72%. This difference between the returns realized by investors and the returns of the funds themselves is called the "behavioral return gap."

​At Bireme, we look at valuations instead of recent performance when making our investment decisions, using tools like the CAPE from the section above. This allows us to invest based on our view of the intrinsic worth of assets, and save our clients from the siren song of the current hot asset or fund. ​

With long-term, valuation-focused dynamic allocation, we hope to reverse the annual behavioral return gap and improve on the returns of underlying assets. We strive to turn a source of perpetual underperformance for other investors into a source of outperformance for our clients.

    Interested in learning more?

​1 Total return of the S&P 500 Index starting from the last business day in the prior decade. Data from Bloomberg Finance LP.
2 CAPE shows S&P 500 Index value divided by the average of its inflation-adjusted earnings over the trailing ten years. Data from Bloomberg Finance LP.
3 See Campbell and Shiller (1988) and Campbell and Cochrane (1999).
4 Hsu et al study "Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies."

Telephone

813-603-2615

Email

info@biremecapital.com

Disclaimer

See here for important disclosures.