Asset Allocation: From Theory to Practice and Beyond, Second Edition. 2021. William Kinlaw, CFA, Mark Kritzman, CFA, and David Turkington, CFA. Wiley.
To create a solid investment process, asset allocators must address a long list of issues, including:
- which assets to choose,
- how to predict risk and return, and
- how to manage exchange risk.
William Kinlaw, CFA, Mark Kritzman, CFA, and David Turkington, CFA, provide advice on these and a wide range of other topics in asset allocation, supporting their recommendations with sound quantitative analysis. Along the way, they dispel some myths and tackle some of the more difficult aspects of investing.
The authors identify seven essential characteristics of each asset class:
- Its composition must be stable (not static).
- They are directly investable.
- The components are similar to each other.
- The asset class is different from other asset classes.
- Investing in the asset class increases the portfolio’s expected utility.
- Picking skill is not a requirement for investing.
- Investors can gain access to the asset class in a profitable manner.
(I would add an eighth: investors must be able to make credible forecasts of performance, risk and correlations with other assets, to implement inclusion in an optimization process. This requirement would exclude, for example, cryptocurrencies).
What do these criteria mean in practice? Global stocks are not internally homogeneous and therefore cannot be considered a single asset class. Instead, the authors identify three equity asset classes: domestic stocks (ie, US stocks for the authors), foreign developed market stocks, and foreign emerging market stocks. Excluded from the asset classes defined by the authors are art (size not accessible), momentum stocks (unstable composition) and, more unconventionally, high-yield bonds, which are not heterogeneous externally because they are similar to investment grade bonds and are therefore part of the corporate bond asset class.
Ironically, the first myth the book addresses is the importance of asset allocation. A widely cited 1986 paper by Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower found that asset allocation determines more than 90% of performance. This book argues, however, that the methodology of this study is flawed because it assumes a starting point of a non-investment portfolio. In practice, the authors show, once investors have made the decision to invest, asset allocation and security selection are likely to be equally important (depending, of course, on the approach of ‘investment adopted). “In the absence of any skill, effort, or careful consideration,” they write, “investors may simply default to a broadly diversified portfolio, such as 60-40 stocks and bonds.”
The outputs of mean-variance optimizers are hypersensitive to small changes in the inputs. However, the authors dispel the myth that this sensitivity leads to error maximization. It is true that small changes in estimates between assets with similar Risk and return characteristics can cause large changes in allocations to each other. Because the assets in question are close substitutes, however, these reallocations have little impact on the distribution of portfolio returns. Conversely, the pronounced sensitivity to changes in inputs is no observed with assets that have different characteristics. In particular, small changes in the valuations of stocks and bonds do not lead to large swings in the optimal allocation between them.
Asset Allocation it covers all the key ingredients of its topic, such as yield forecasting, optimization and currency hedging. The chapter on rebalancing gives a good idea of what practitioners will find: a mix of detailed quantitative analysis and practical advice, with scope to draw your own conclusions. Investors must evaluate the trade-off between the cost of rebalancing their portfolios to target versus the cost of sticking with a suboptimal mix. A section on a dynamic programming methodology concludes that this approach is computationally infeasible. The authors then present an optimal rebalancing methodology, the Markowitz-van Dijk heuristic approach. Its costs (5.4bp) compare to the costs of schedule-based rebalancing (5.5bp to 8.9bp), tolerance band rebalancing (5.8bp to 6.9bp) and no rebalancing (17.0 bp). This detailed analysis supports a simpler conclusion for those of us dealing with individual clients, for whom behavioral biases present the greatest threat to long-term success: have a long-term plan, rebalance your portfolio with this plan, but don’t bargain. too often.
The book presents high-level quantitative analysis to explore some of the more difficult aspects of asset allocation. For example, the authors assess the likelihood of future scenarios using a technique originally developed by Indian statistician PC Mahalanobis to characterize human skulls. They use a hidden Markov model to develop a regime switching approach. In addition, they identify the fundamental drivers of stock-bond correlations using statistically filtered historical observations.
Despite its reliance on such sophisticated techniques, this new edition of Asset Allocation it is accessible to those of us who work with equipment how much instead of in they. Each chapter provides an independent analysis of one of the 24 aspects of asset allocation. I find myself regularly returning to this book for the framing of the issues I face, the authors’ analysis, and their concise presentation of the end result.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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