Conjecture 5: The current asset allocation paradigm is flawed.
There is no doubt that many of today’s approaches to asset allocation are flawed. This is the case for both financial planners using asset allocation to assist individual investors, and product providers using asset allocation to construct investment products (including the default-investment option offered by superannuation funds). Some of the obvious flaws are: naive use of simplistic asset classes; naive processes; no diversification of insight; endemic peer and agency risk; control by vested interests; slow governance; and the illusion that retaining control will result in better outcomes.
Conjecture 6: There are lots of ways to skin the asset-allocation cat
There are at least five different dimensions in which an asset allocation practitioner can vary:
1. What is allocated
2. The skills required in portfolio construction
3. Time horizons
4. Process and governance.
Conjecture 7: Improve diversification of critical asset allocation by allocating to other processes and insights.
The typical approach to asset allocation can be thought of in terms of specialist chefs each creating a course to make an outstanding meal. Each chef represents a traditional asset class. They use particular ingredients and represent different sector-specialist investment managers. There is a huge degree of options available to each chef as they prepare their course. There is similarly a wide range of ways a fund manager can invest within each asset class to gain returns.
But consider the processes and skill that go into deciding how each course should fit together to create a great meal. Skill and effective processes should also be applied when combining sector-specialist investment strategies in a portfolio. However this is typically done by non-experts with slow processes and an obsession with agency risk.
However, as Conjecture 6 demonstrates, there are many ways to skin the asset-allocation cat. In my view, these are not exploited by most asset allocators. It is possible to improve diversification of critical asset-allocation activities by considering processes and insights from external sources.
Think again of the great meal. Why not give chefs free rein to create the best meals they possibly can rather than restricting them to serving either an entree, main course and dessert? Similarly, investors should consider managers that can provide new asset allocation insights rather than mandate them to invest only in one asset class.
A key point to remember in this approach: each specialist chef/ manager should be awarded an independent mandate with no attempt by the client to influence the manager’s approach to asset allocation. This probably argues against setting a benchmark based on the return of a static allocation to traditional index proxies. Also, it is vital to use managers with genuine skill: there is simply no point in diversifying into mediocrity.
