Byron McKeeby has long been a friend to this blog. Here he questions the over reliance on asset allocation to pay collective pensions, when the chief consideration is the short -term volatility of the asset classes. What follows is Byron’s argument displayed on comments, you can see other comments of Byron on this subject on this link
I did note this in PLSA’s published response to the LGPS consolidation consultation:
“It is widely recognised that setting the right asset allocation is the most important factor in driving long-term investment returns for a scheme.”
PLSA’s scribes therefore still seem to be peddling the flawed Brinson research from the 1970s and 1980s in the mid 2020s.
Unfortunately, both the research conclusions and the interpretation of those conclusions are wrong.
The problem with Brinson’s analysis was its focus on explaining short-term portfolio volatility rather than total portfolio returns.
LGPS surely should be more concerned with the range of likely outcomes over their longer term investment planning horizon than the volatility of short-term returns.
Their pools will be contemplating LDI and buying gilts next?
Asset allocation policy explains only a small fraction of ten-year returns, but a large fraction of the variation of short-term returns.
Persistent small increments to periodic returns compound over time, while the volatility in returns grows more slowly (and often reduces) as the investment period is lengthened.
When analysing returns for short periods of time, it is easy to miss the significance of small persistent increments to returns in all the noise of marking to market.
To give more detail, several issues have been identified with the Brinson research, but those who trumpet that asset allocation trumps everything have probably never looked into these:
1. Empirical flaws
The original studies by Brinson et al. were based on a limited dataset of US mutual funds and pension plans, and did not have actual data on their strategic asset allocations.
They assumed that the 10-year mean average holding of each asset class was sufficient to approximate the appropriate normal holding, which is a significant limitation.
2. Methodological Flaws:
The studies did not account for the detailed mandates given to portfolio managers, which often include constraints that limit the potential impact of security selection.
This means the studies may have underestimated the importance of security selection in particular
3. General Applicability:
The conclusion that strategic asset allocation dominates other factors has been widely accepted by investment consultants (and the PLSA’s scribes) without sufficient empirical validation across different contexts and time periods.
Drawing general conclusions from such limited research is methodologically unsound.
4. Practical Implications:
The emphasis on strategic asset allocation has led to a more rigid approach in portfolio management, where the potential benefits of active management and security selection are often overlooked or constrained by the terms of market-relative mandates.
(Much so-called “active” management, however, may be closer to “passive” because of the use of market benchmarks and a fixation upon short-term volatility.)
Brinson’s research oversimplifies the complexities of portfolio management.
A more balanced approach, recognising the importance of both asset allocation and security selection, as well as market timing and transaction costs, is preferable.
Sources: such as Journal of Financial Planning: William W. Jahnke’s February 1997 piece, “The Asset Allocation Hoax.”
Henry asked me to provide further reading:
The academic research, which criticises misuse and abuse of “Brinson et al”, includes the following in no particular order of merit:
William Jahnke
https://www.financialplanningassociation.org/sites/default/files/2021-08/AUG04%20The%20Asset%20Allocation%20Hoax.pdf
Roger Ibbotson
https://blogs.cfainstitute.org/investor/2020/03/25/roger-g-ibbotson-what-works-in-asset-allocation/
John Woods
On the Political Economy of Pensions Regulation (behind a paywall)
which Henry covered a few years ago with the Cambridge Journal of Economics article to which he had been alerted by
Warwick University subscriber, Emeritus Professor Dennis Leech.
https://henrytapper.com/2016/12/25/happy-christmas-var-is-over/amp/
Henry asked me to provide further reading on this topic, as follows:
The academic research, which criticises misuse and abuse of “Brinson et al”, includes the following in no particular order of merit:
William Jahnke
http://www.financialplanningassociation.org/sites/default/files/2021-08/AUG04%20The%20Asset%20Allocation%20Hoax.pdf
Roger Ibbotson
blogs.cfainstitute.org/investor/2020/03/25/roger-g-ibbotson-what-works-in-asset-allocation/
John Woods
On the Political Economy of Pensions Regulation (behind a paywall)
which Henry covered a few years ago, referencing the Cambridge Journal of Economics article to which he’d been alerted by Warwick University subscriber, Emeritus Professor Dennis Leech.
henrytapper.com/2016/12/25/happy-christmas-var-is-over/amp/
The original Brinson et al research sparked a wave of related papers, most notably those of Ibbotson and his CFA colleagues, who may have advanced understanding of asset allocation’s relative impact on investment performance.
They collectively demonstrate the importance of staying in the markets, but also doing and monitoring strategic asset allocation.
While asset allocation remains a critically important piece of the investment process, active managers may argue that its importance was much overstated by Brinson’s proponents.
But herein lies another conundrum.
We accept that the majority of so-called “active” managers underperform passive investing in market index funds.
To improve client outcomes, investment consultants and other advisers must surely come to terms with this undeniable.
Yet, over the past several decades, it seems to me that they/you have only intensified a quixotic quest for “outperformance”.
Your collective failure (ie consultants as a whole do NOT add value) has lumbered clients with overly diversified portfolios, unnecessary and unrewarded “active” fees, and/or unnecessarily invested in expensive “alternative” assets which may only add value to a small sub-set of highly skilled and patient investors.
The consequences are sub-par performance (not good, unlike in golf), higher fees, with costly neglect of more important challenges and targets.
Why can’t advisers and consultants face up to the truth of your collective underperformance?
Because, even before the age of AI, you fear it will lead to your redundancy?
It’s ironic, therefore, that the opposite is true.
Clients need you to hone their investment beliefs and objectives, calibrate their risk tolerances, optimise their capital and income allocations, and keep their strategic strategy allocations under review.
By spending less time on unnecessary tweaking of portfolio allocations, the constant firing and re-hiring of managers, the unnecessary and often ill-timed forays into esoteric assets, you could better serve your clients by focusing them on what really counts.
Perhaps the PLSA’s scribes may like to reconsider their sweeping introductory statements about strategic asset allocation next time around?
I’m sure it’s too late to include this debate anywhere in March’s investment conference, an NAPF/PLSA “event” I used to attend in Eastbourne and later on in Edinburgh, before my retirement.
Sadly, I hear recent conferences have been long on back-slapping and short on evidence-based investment research or, dare I suggest it, learning from past mistakes.