Asser Allocation Portfolio Investment

1. The Asset Allocation Model
And Pension Value Investing
Christopher M. Quigley
B.Sc., M.M.I.I., M.A.
www.wealthbuilder.ie
Academic Background
“In 1986, Gary Brinson L. Randolph Hood, and Gilbert L. Beebower (BHB) published a study
about asset allocation of 91 large pension funds measured from 1974 to 1983. They replaced the
pension funds' stock, bond, and cash selections with corresponding market indexes. The indexed
quarterly returns were found to be higher than pension plan's actual quarterly return. The two
quarterly return series' linear correlation was measured at 96.7%, with shared variance of 93.6%.
A 1991 follow-up study by Brinson, Singer, and Beebower measured a variance of 91.5%. The
conclusion of the study was that replacing active choices with simple asset classes worked just as
well as, if not even better than, professional pension managers. Also, a small number of asset
classes were sufficient for financial planning. Financial advisors often pointed to this study to
support the idea that asset allocation is more important than all other concerns, which the BHB
study lumped together as "market timing” One problem with the Brinson” study was that the cost
factor in the two return series was not clearly discussed. However, in response to a letter to the
editor, Hood noted that the returns series were gross of management fees.”
With the development of Exchange Traded Funds (ETF’s) it has never been easier to embrace
the concept of “Asset Allocation Investing.” These ETF’s cover stocks, commodities, bonds,
currencies, real estate et al. As the BHB study above indicate an active managed pension fund
that chooses individual stocks and bonds does not necessarily mean a more profitable portfolio.
The use of indices or ETF’s as investment vehicles however does remove a great deal of the risk
associated with “raw” equity, real estate, commodity or bond ownership.
The Value Approach
I am an enthusiastic value investor. I like the concept and it has proven its profitability over the
last decade that I have been active in the markets. I believe bringing the techniques of value
portfolio management to asset allocation investing is very exciting. Such a strategy blends
conservative diversification, with dollar cost averaging (saving in normal parlance) and technical
analysis of long term asset class prices.
How does it work in simple terms? For example let us have our investor choose say 3 asset
classes for his/her portfolio: Stocks (An ETF of The S & P 500), Real Estate (An ETF of top
Real Estate Players) and Gold (An ETF of the commodity). The idea now is to bring into the
equation some technical assessment of long term value. Each of our classes will have a different
value determinant, as set out below:

2. Stocks: PE Ratios
Real Estate: Rental Income Multiples
Gold: Inflation Trend Index of Price
With each type of asset we will use in our analysis a long term graph indicating our indicator’s
technical/historic trend. Those asset types currently priced significantly beneath the long term
asset-class-average would be regarded as undervalued and those assets priced significantly above
the long term asset-class-average would be viewed as overvalued.
Now with a pension portfolio we need to obviously have diversification among several asset
types but the key to achieving above average returns involves a little more effort. The smart
thing to do is invest a disproportionate amount into the class that is undervalued and discharge
those classes that are overvalued, in a systematic manner. Remember we will be looking at these
shifts in allocation emphasis happening over years not days, weeks or months. Ideally the
portfolio should be saved into over a long period of time. Such an approach removes the
potential for capital loss through trying to “time” the market on entry. This approach is continued
as long as the fund is active. As the portfolio term reaches maturity all classes are systematically
sold and shifted into cash starting with those most overvalued. This policy prevents the fund
from receiving “value shock” just when liquidity is most needed.
It is interesting to note that some of the world’s best managed “endowment” funds (such as the
Harvard Endowment Fund) use the asset allocation approach to investing It has proven
spectacularly successful and is one of the reasons more pension funds are choosing this simple
self-managed approach rather than sub-contracting their decision making out to conventional
equity specialist. The dreadful returns achieved from “passive” equity investment since 2000 has
hastened the trend as has the fabulous returns earned through commodity and bond investment
over the last three-five years.
Reference: Wikipedia