Asset Allocation and Buckets

Merrill Lynch Embraces Buckets
Last week, I mentioned Merrill Lynch's move toward "goals-based" advice with the appointment of its new CEO, Ashvin Chhabra.

Chhabra's position paper on the subject, "Beyond Markowitz," is notable for its use of allocation buckets. Chhabra recommends that investors separate their assets into three groups. The Personal Risk group consists of a residence and cash and is intended to provide for basic needs. The Market Risk group consists of roughly the standard 60/40 equity mix and is for maintaining the investor's lifestyle. Finally, the Aspirational Risk group consists largely of alternative assets such as options and hedge funds, with the goal of enhancing the investor's lifestyle. (This could also be called the Three Bears approach.)

This recommendation runs counter to the advice of Nobel Laureate Harry Markowitz, which holds that optimal asset allocation is conducted across an investor's entire portfolio, rather than done over different bits and pieces. Investment mathematics unambiguously support Markowitz's contention. But psychology leans the other way, as investors intuitively tend to think in buckets--first, providing for basic safety (Personal Risk); second, making a profit with additional sums (Market Risk); and then third, if the investor is fortunate enough to be wealthy, taking fliers with house money (Aspirational Risk). Chhabra labels this framework as "pragmatic"--a word that acknowledges his swap of theoretical accuracy for practical comfort.

Morningstar's Christine Benz shares Chhabra's view. She writes, "I am a fan of bucketing because the framework helps people get off the 'income only' kick, which in my mind is the single most worrisome behavior that retirees exhibit these days. They have portfolios full of MLPs, preferred stocks, junk bonds, foreign bonds, and all of this other gobbledygook, all in the interest of generating a livable yield. A bucket strategy helps people visualize what a total return portfolio should look like." Here, you can see John Ameriks of Vanguard, financial advisor Harold Evensky, and Christine discuss the benefits of buckets. For more on buckets, read this article by Michael Kitces.

Being pragmatic by nature, I concur. (Apparently, Markowitz himself also doesn't see the need for pure science, as he once stated that he owned a portfolio made up of half stocks and half bonds so that he wouldn't feel regret for holding the wrong asset.) That said, it's important to acknowledge the other side of the argument. Buckets appeal from the broad perspective but are trickier to implement because they have more moving parts. They also are arbitrary and less conducive to sensitivity testing, which undermines the discipline of the allocation process. Pragmatism does come at a cost.

Give or Take 40
This headline from a blog caught my attention: "Wall Street Is a Rentier Rip-Off: Index Funds Beat 99.6% of Managers Over Ten Years." The article goes on to state: "Frequent contributor B.C. recently screened 24,711 funds on Yahoo Finance's fund screener and 17,785 funds on The Wall Street Journal's online screening tool. The results were sobering, to say the least: using a basic set of criteria, the first screen turned up a mere 5 managers who beat the S&P 500 index over five years. Using a slightly different set of criteria, the second screen found 71 funds out of 17.785 outperformed the index over 10 years. That's .4% of managed funds, i.e. an index fund beat 99.6% of all fund managers."

Sobering is indeed the least way to describe those findings. Other ways include fantastical, imaginary, and hallucinogenic. Through March 31, 2013, over the trailing five years, 7,278 out of 20,690 U.S. mutual funds outgained the unmanaged S&P 500 Index. Narrowing the field to equity funds led to 4,445 funds out of 11,259. Limiting it further to the peer group of large-blend stock funds resulted in 426 funds out of 1,498. Those percentages are 34%, 39%, and 28%, respectively. The 10-year figures were stronger for the active managers. (Yes, my numbers are not adjusted for survivorship, but that effect isn't remotely large enough to get to 0.4%.)

Indexes usually fare well against active funds over a long time period, but never anything like a 99.6% success rate, except under three conditions. One, the index and funds are so mismatched that they're effectively doing different things; two, the study has a catch to it; or three, the math is wrong. (The answer here is the second, as the study was nowhere near as straightforward as the initial paragraph indicates. Several additional screens weeded out nearly every winning active fund.)

Contronyms
Yesterday, I mentioned that peruse means both to read with much care and to read with little care. It turns out that there is a word to describe words like peruse that have two opposite meanings: contronym. Morningstar's Russ Kinnel offered up scan as another, similar example of a contronym. Scan can be used to mean a thorough, point-by-point examination of a subject, and of course it is also commonly used to mean a quick, surface glance. 

As my wife's grandmother would say about English, "Call it horse, pronounce it dog." Or in this case, call it horse and have it mean horse and anti-horse.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.