This is my most recent article in a series that evaluates the dark side of asset allocation. In Part I, I discussed the unsavory fact that asset allocation frequently leads to important unintended consequences. This theme was extended to Part II as well, where I pointed out that treating frontier and emerging markets as an asset class can starve frontier and emerging markets of much needed capital, thus impoverishing them. In this article I discuss more of the dark side of asset allocation. Namely, that these strategies themselves rarely submit themselves to the independent benchmarking that, for example, active managers are usually subjected.

Active Management Scrutiny is Standard

In the current era of investment management, active manager performance is subject to a tremendous amount of scrutiny. For example, performance is benchmarked, typically to an index. Furthermore, various measures such as style drift and tracking error are used to ensure that active investment managers are who they say they are relative to their stated style. By the way, this is not the same thing as strategy, though it is frequently treated in this way.

I think it is incontrovertible that performance measurement and benchmarking is necessary and valuable. These activities allow us to evaluate the ability of investment managers to do what they say they intend to do. However, I think that the current system of using the style box and indices in service to the benchmarking idea does more harm than good. But I will stop right there because that is a digression rabbit hole for me, and barricades might be formed and weapons drawn. Let us, mercifully, move on.

More important is to ask why style boxes, style drift, and tracking error would be so important. The reason is that someone, somewhere wants investment managers that are predictability of a style. Why? Because someone, somewhere is an asset allocator and they are looking to fold an individual manager of let’s say, style XYZ, into an overall asset allocation strategy, yes?

The handcuffs put in place by this strict adherence to style makes it very difficult to deliver undifferentiated returns (read: outperformance) for active managers. Given the consistently found result that active managers stink has led to asset allocators seeking out the lowest cost way of delivering style XYZ. And we all know the moral of that story, right? Passive strategies, including ETFs, are the lowest cost way of getting style XYZ.

After all, the real value add comes from an asset allocation strategy that is in service to a client’s stated return and risk preferences, their financial condition, their financial goals, and their age. Right?

What this looks like in practice: If someone is risk intolerant then we increase their allocation to blue chip and dividend paying stocks, and if they are older, too, then we might dial down their allocation to equity and dial up their allocation to some fixed income, right? I am certain you will agree with me that this is common industry practice. I could go on.

But herein lies another part of the dark side of asset allocation.

Asset Allocation Scrutiny is Not Standard

If we agree that evaluating the performance of investment strategies is a valid activity – and again, I think that is incontrovertible – then let’s ask why asset allocation strategies like the one I just described are so rarely benchmarked themselves.

In the above scenario I described, if a private wealth manager, for example, or an investment consultant, as another example, fails to achieve a client’s desired financial goals what is usually offered up as the reason for why?

If the asset allocating private wealth manager or investment consultant has <gasp!> chosen actively managed funds then they can reliably blame the unexpectedly poor performance of the active managers themselves. This is almost always the case given the inability of most active managers to deliver alpha consistently. So, the possibly failed asset allocation is given a free pass.

Say, though, that the active managers chosen have outperformed, or that the private wealth manager or investment consultant has chosen passive strategies, then who is to blame for the client’s lack of success? In this situation we can reliably blame the unexpected performance of the markets. This is because everyone knows that past performance is not indicative of future results. We also all know that no one can predict the future magnitude or direction of financial markets consistently. Those tricky, wild, untamed markets! Again, the possibly failed asset allocation is given a free pass.

Now let’s consider the most insidious of scenarios, the client is achieving her goals, but is actually underperforming had the asset allocation been subject to benchmarking. If this situation occurs then the client and the adviser have practically zero-incentive to engage in a course correction. The client is likely ignorant that returns have been left on the table, and the adviser is relieved that possibly difficult conversations with a dissatisfied client are avoided. You know the drill: possibly failed asset allocation gets a free pass.

Be honest, how many asset allocation strategies are subjected to any consistent standard of benchmarking in the same way that active managers are subjected? If so, what are the tools being used? Are they evenly applied? By all firms?

Within individual asset allocating firms there may be some level of benchmarking, but I doubt it. Even if these post-mortem structures are in place, what if the client leaves the private wealth manager or the investment consultant firm? In uprooting, can our client reliably go to another firm and be assured that their past returns are going to be comparable going forward by the same standard at the new firm? Absolutely not.

How is this good for the end client? To me, this is one of the areas of undiscovered country of the investment management business, and it is time that the industry figures this one out, perhaps with the help of academics, too.

Next is my final edition in this series where I put forth some ideas for how to move asset allocation more toward the light side.

Jason A. Voss, CFA – Your Next Excellent Hire

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