Asset Allocation 2.0 (and 3.0, 4.0, etc.)

Richard Bernstein of RBA Advisors came out this week with his firm’s version of Asset Allocation 2.0:

Traditional asset allocation models seem obsolete. The much heralded “Endowment Model” failed in 2008, yet asset allocators continue to cling to it as much as the Peanuts character Linus hung on to his blanket. However, the global financial markets have changed dramatically, and the macroeconomic backdrop that fueled the success of the endowment approach no longer exists.

RBA’s approach, Asset Allocation 2.0™, is based on a different asset allocation construct. We no longer pigeonhole investments into traditional categories, such as Large Growth or Value, Small Growth or Value, High Yield or Distressed debt, Absolute Return, or the like. Rather, we group investments based on their returns and risk characteristics.

To our clients, Asset Allocation 2.0™ looks no different from traditional asset allocation. Our external reports show exposures to traditional asset categories. Internally at RBA, however, we view asset classes very differently. An investment doesn’t necessarily belong in a fixed-income category if it acts more like an equity investment than a fixed-income investment. An equity investment shouldn’t be characterized as equity if it acts more like a fixed-income investment than an equity investment. Similarly, an alternative investment shouldn’t be classified as alternative if it acts like traditional equity or fixed-income.

Asset Allocation 2.0™ also incorporates the productivity of an investment. Productivity does not mean efficiency in an efficient frontier analysis. Rather, it means incorporating a cost/benefit analysis. Fees and lock-ups make little sense when similar exposures can be gained in investments without onerous terms.

I’ve seen Bernstein speak in the past and am a huge fan of his work. He makes some great points in this piece, especially when it comes to the changing nature of correlations between investments. He rightfully has some concerns about the Endowment Model of investing in that it failed as a provider of liquidity when it was most needed during the financial crisis. And I completely agree that the best way to think about asset allocation is in terms of risk and return characteristics.

But at the end of the day, a new name for asset allocation is mostly just window dressing. In my dealings with various foundations, endowments and pensions over the years I’ve seen this game of musical chairs play out over and over again as asset allocation definitions and models are constantly changing. Institutional investors assume it’s a bad look to stand pat with their strategy so every couple of years they rearrange the furniture, so to speak. Granted it’s the same couch, table, love seat, chair and ottoman. It’s just now they’re in in a different place with a different name. That is until they get restless and decide to add new furniture to the mix.

Asset allocation was fairly straight forward in the 80s and 90s as most funds had allocations to equities, fixed income and cash. As the Yale Model grew in popularity in the 2000s, the new mix was equities, fixed income, cash, hedge funds and private equity. Investors finally realized that hedge funds and private equity aren’t really asset classes, but fund structures. So next came some variation of equities, fixed income, cash, absolute return and real assets (and many other odd offshoots of this as well).

Following the 2007-09 financial crisis many institutions decided to stuff as many hedge funds as they could into their portfolios by adding equity-oriented funds into their equity bucket and fixed income-oriented funds into their bond bucket. This changed the nature of their fund’s risk and return characteristics as it’s a completely different ball game in terms of fees, liquidity, leverage, market exposure and blow-up risk. Add to this the fact that there’s no such thing as funds that can consistently deliver absolute returns and you end up with a huge mismatch between a fund’s goals and its asset mix.

I’ve found that the more money involved in a portfolio the easier it is for investors and committees to overthink things and make them more complex than they need to be. Consultants and investment offices are constantly trying to prove their worth by changing risk buckets and asset allocation guidelines to make it look like they’re being innovative and hands-on.

Yet the only thing that really matters are the expected risk and return characteristics of the given investments and asset classes in a portfolio. Calling something by a new and exciting name is not going to change the performance of your portfolio. Most of the time it’s just an additional layer of complexity in an already complex world. It makes things harder to understand and easier to see subpar performance.

There’s no substitute for understanding what you own and why you own it. You have to be able to understand the behaviors of the investments in your portfolio and how they generally work together. In my mind this is the only way you can survive periodic market disruptions like the one we are currently experiencing.

Asset Allocation 2.0 (Advisor Perspectives)

Further Reading:
The Importance of Continuity in an Investment Plan
Advice Doesn’t Have to be Complicated to be Good

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What's been said:

Discussions found on the web
  1. Evan Levine commented on Jan 20

    Hi. Great article as usual. I just have one question: How come there are banners on the site enticing people to ” Buy stocks” at 4.95 etc… Doesn’t that approach contradict the philosophy of your content? Thanks!

    • Ben commented on Jan 20

      Ads are through Google so they’re based on your profile and I have no control over them. I put a ton of time and effort into this site so making some money in return from ads helps (even though it’s a small amount). Money goes towards my daughter’s 529 plan. Most people ignore Internet ads anyways.

  2. John Richards commented on Jan 20

    I wonder how Mr. Bernstein classifies EM Bonds(?!)… but really, it seems to me that it’s about finding an approach that works for you. I used to invest in EM Bond funds, now I don’t – historically they don’t seem to have worked all that well with the other assets in my current portfolio in such a way as to improve portfolio returns or lower portfolio volatility. As an asset class, there’s nothing wrong with them, and I’m sure they could be an effective part of a portfolio that’s structured differently than mine… or hey, I could very well be missing the boat. In any case, if I even had the capability of separating EM bonds into a couple segments based on different return and volatility characteristics (most of us 401k investors are lucky to simply have an EM bond fund available to invest in), it still would need to have the right return and variance characteristics to generate a synergistic relationship with the rest of my portfolio (as you say at the end of your post) or else it adds no value to my investment approach. Knowing why you invest the way you do does certainly make the downturns easier. In fact, I’m excited about the additional buying opportunities that are forming.

    • Ben commented on Jan 20

      Good to know someone is excited because it seems like everyone else is freaking out.

      • mugabe commented on Jan 21

        lol .. this is nothing … yet

  3. Jim Wang commented on Jan 21

    I think you can draw some parallels with sports here. In basketball, you have the five basic positions but within those positions you have a lot of variation. Where does the line between power forward end and center begin? A player can play multiple positions and maybe you could get more accurate data if you were to make 10 different position types, using just five of them on the court. In the end, it’s about performance and 5 roles is “good enough.”

    For asset allocation, is additional complexity really going to get you anything except headaches and enough analysis paralysis that you don’t act? 🙂

    • Ben commented on Jan 21

      Good analogy. Simpler is almost always better in my book.

      • Jim Wang commented on Jan 22

        According to the subtitle of your book, it’s literally in your book right? 🙂

  4. Boris Kozhukhovskiy commented on Jan 21

    Hello Ben. I have a question, Close, but not exactly about asset allocation.
    How do you think, what part of all capital (assets) should be invested in market? How much must left for real estate, cash , or personal business?

  5. Grant commented on Jan 22

    Certainly, we humans tend to feel that more complexity is better, particularly if we are new comers to a given subject. And you need to know a lot about any given subject to know what is really important about it. For me, everything is either a stock (a risky asset) or a bond (a riskless asset) – in this frame, a government bond. Everything else is window dressing – many other things can be added that may, or may not, add value, but the added complexity makes it not worth it.

  6. UofODuck commented on Jan 22

    It seems a little disingenuous to fault the performance of traditional asset allocation models during the onset of the Great Recession since, as I seem to recall, just about every asset class we thought was non-correlated suddenly began to behave like every other asset class and sink like a rock! Haven’t we seen this before in yield tilt, enhanced beta, etc.? Just like breakfast cereal I suppose, you have to periodically change the color or shape of the box and throw in a new toy in order to sell the same old cereal. “New and Improved” does not necessarily mean better in the investment business.