Fourth Key: Asset Allocation over Security Selection
The last five years in particular have seen the ascendance of so-called passive management through exchange-traded funds. This is only a further innovation on the index mutual fund that has been around for several decades. The SPIVA Scorecard, a measure of the S&P Dow Jones Indices against alpha, and other past studies document the difficulties active management faces against indexes. The straightforward arithmetic is that the average manager/investor will earn less than the index after transaction costs, something it does not require even a high school education to understand. In fact, it may be fair to say that the point has become tiresome. Bill Sharpe made this point back in 1991 in his article, “The Arithmetic of Active Management.” Today, an all-ETF portfolio is around every corner. For the solely expense-focused investor, ETFs have been a great innovation.
For the income-focused investor, however, they have been much less so.
While choosing wisely between passive and active options and prudently among managers will continue to be important, the advisor of the future will care more about his or her own skills or the skills of a third-party manager as an asset allocator. Or, to say it in today’s parlance, advisors will care more about how they manage beta of every kind (such as the home bias). Advisors will be factor managers, sector managers and asset class managers, often at the same time.
While strategic asset allocation forms the slab and floor plan of our portfolio construction, our tactical asset allocation and our selection of investment vehicles will help us complete the rest of the building. As asset allocators, we believe there are ways that we and other advisors can add another source of alpha. This includes not only market timing—the no-no of efficient market investors—but also the choice of which assets to hold at different times, an aspect of asset allocation that the efficient market hypothesis does not adequately address.
A strategy that we have successfully implemented for equity energy investments since 2012, for example, has mitigated the downside risk of the asset while also improving the absolute and risk-adjusted returns. A momentum strategy using price to the 10-month moving average of an equity energy index, as well as the 12-month-minus-one-month price level of the index against the current price, has given us a valuable but not perfect indicator to go long on the asset at some times—and at other times to park those assets temporarily in an interest-bearing, highly liquid cash-like investment.
While many approaches abound that might enhance the traditional asset allocations of 60/40-like portfolios, a fiduciary obligation should set clear expectations for the probability of success, for the required time horizon to realize success, for the magnitude of excess returns, for some measure of volatility and for clarity about what the worst-case scenario would be for a particular asset allocation choice.
William D. Olinger III, CIMA, is managing partner with Koss Olinger and Company in Gainesville, FL.
Benjamin Doty, CFA, is senior investment director at Koss Olinger and Company.