Is Asset Allocation Dead?

Asset allocation, the practice of spreading a portfolio across different investments to diversify risk, failed miserably in 2008 when almost all asset classes fell together.  So is asset allocation dead?  Yes, and no.

Failure of a Fail-Safe Strategy

The WSJ’s Tom Lauricella does a nice job of explaining what happened in 2008 in his recent piece, Failure of a Fail-Safe Strategy Sends Investors Scrambling.  Investors and their advisors thought they were well positioned to manage risk and preserve wealth by going beyond just stocks to invest in bonds, commodities, real estate, international equities and emerging markets.

What they didn’t anticipate is what happened.  In a year when the S&P 500 lost 37%, the MSCI index of major markets in Europe, Asia and Australia lost 45%. The MSCI emerging-markets index fell 55%. Real-estate investment trusts declined 37%, high-yield bonds lost 26% and commodities fell 37%. In Lauricella’s words, “The financial crisis has sent many financial advisers, academics and investors back to the drawing board.”


Asymmetrical Beta

To build portfolios, financial advisors use models that combine investments that don’t move up or down at the same time, or at least by the same degree. The idea is that by spreading investments around, returns will be smoother and big losses on a single investment are avoided. Adding asset classes also ensures that investors will get at least some gain if a particular part of the market posts big gains.

The fundamental issue is the underlying science of the approach.  To find investments that don’t move together, financial advisors look at beta which combines correlation (the tendency for investments to move together) with co-variance (the relative volatility of the two investments).  A beta of one signifies that two investments move perfectly together and to the same degree.  A beta of zero means the opposite.

Financial professionals have been trained to measure beta across bull and bear markets to determine a single answer.  We now know that is wrong.  Turns out that beta in bull markets can be different from bear market beta.  In other words, beta is asymmetrical.  (see the WSJ’s interactive chart, data courtesy of PIMCO).

In bull markets, various asset classes generally head up, but in different directions and at different rates.  However, in a severe bear market like 2008, almost all asset classes pull back and with a similar degree of severity.  This behavior suggests that financial analysts, advisors and their clients manage portfolios with 2 betas – one for up markets and another for down markets.

The New Asset Allocation Approach

2008 taught us that a buy, allocate and hold strategy is not enough.  Asset allocation needs to take into context current market conditions and trends.  Advisors who last summer told their clients to sit tight and wait it out need to step back and reevaluate their role.  Investors who are not working with advisors who are contrite and newly purposed should be looking for new advice.

In the mean time, investors should note that the two asset classes that didn’t fall in concert with the S&P 500 in 2008 were short-term and inflation-protected US Government Bonds.  ETF investors can gain access toShort-Term US Government Bonds through the Barclays 1-3 Year Treasury Bond Fund (SHY).  SHY tracks an index that includes all publicly issued, U.S. Treasury securities that have a remaining maturity of between 1 and 3 years, are non-convertible, are denominated in U.S. dollars, are rated investment grade.

Exposure to US Treasury Inflation Protected Securities or TIPS can be gained through the Barclays Capital TIPS Bond Fund (TIP) or the SPDR Barclays Capital TIPS ETF (IPE) which both track an index that includes all publicly issued, U.S. Treasury inflation-protected securities that have at least 1 year remaining to maturity, are rated investment grade and have $250 million or more of outstanding face value.

See the Short Term Fixed Income ETF Directory  and the TIPS Fixed Income ETF Directory for more ETF investing choices.