The rising popularity and expanding menu of multi-asset class funds suggests that investors are eager and willing to farm out the asset allocation decision to professionals. Morningstar Principia lists over 1,700 mutual funds and ETFs that engage in some form of multi-asset class investing under one strategic roof. These products are branded under several labels, such as global asset allocation or target date funds. There’s the old standby term balanced fund as well. But no matter what you call them, they all share a common link: managing asset allocation. Some investors think owning these funds relieves them of the chore of making strategic investment decisions, but that’s only partly true.

Asset allocation, of course, is a critical factor in multi-asset class portfolios. There’s plenty of debate about exactly how much influence asset allocation harbors, and what it means for investing. A widely read paper from a few years back, for instance, asks if asset allocation explains 40%, 90% or 100% of portfolio performance? The answer? All three. It depends on how you define the question.
But if there’s one thing most strategists agree on, ignoring asset allocation is asking for trouble. As Morgan Stanley’s David Darst advises in his 2008 book The Art of Asset Allocation, “Asset allocation is the most important factor in the performance equation of a multi-asset portfolio.”
It’s also true that designing and managing a productive asset allocation takes time and effort, which inspires owning funds that take responsibility for this critical task. But with 1,700-plus funds at your disposal, the question arises: How to pick a product (or products) that are appropriate for your investment objectives, risk tolerance, etc.?
As with asset allocation, there’s no simple answer. There is, of course, a useful benchmark to start the analysis: the market portfolio. As I discuss at some length in my book Dynamic Asset Allocation, a broad, passively allocated portfolio that owns all the major asset classes according to market values is the optimal portfolio for the average investor for the long haul. The challenge is figuring out how (and if) your asset allocation should differ from this default mix. In addition, you need to develop a strategy for managing a customized asset allocation through time. It’s no wonder that many investors opt to let someone else do the heavy lifting.
But giving someone else responsibility to run your asset allocation strategy creates a new set of challenges, starting with the all-important issue of choosing a fund. That’s effectively a decision of choosing an asset allocation policy, of which there are countless options. Making an informed choice is tougher than it sounds, and not only because there’s a large and growing list of funds focused on asset allocation. Indeed, as consultant Ron Surz (president of Target Date Solutions) is fond of noting, multi-asset class target date funds are complicated and fraught with hazards, as he explains in an essay on the topic.
In general, there are two basic ways (excluding leverage) to add value with asset allocation relative to the market portfolio, which is the benchmark for all multi-asset class strategies. One is focusing on dynamically managing the asset class mix. In pure form, this approach makes no attempt to choose the securities (or active funds) within an asset class. Instead, the goal is managing the asset classes by adjusting the weight of the broad components based on passive benchmarks. Using index mutual funds and ETFs is ideally suited to this approach, and it’s the preference for managing the model portfolios of The Beta Investment Report. Although this is no silver bullet, it does have the virtue of clarity. In other words, if you succeed or fail in trying to add value using only conventional index funds, there’s no mystery in identifying the source of the results.
Another strategy calls for picking securities (and/or actively managed funds) within each asset class in an effort to beat the various benchmarks. Quite often this is combined in some degree with the first strategy noted above. The net result, the manager is actively managing the asset allocation and choosing securities/funds.
The problem is that it’s difficult to do so many things simultaneously and still add value that’s cost effective relative to the benchmark—the market portfolio of all the major asset classes weighted passively. Let’s put some numbers behind this statement. First, we’ll define the market portfolio as it’s used on the pages of The Beta Investment Report. The Global Market Index (GMI) is passively weighted among global stocks, bonds, REITs and commodities, which are based on 11 broad subcategories (cash makes it an even dozen), all of which we update and analyze monthly in the newsletter and in brief on these digital pages, including this overview from earlier this month.
GMI earned an annualized total return of 4.8% over the last five years through March 31, 2010. As we discuss in detail in the next issue of the newsletter (May 2010), replicating GMI with ETFs reduces this paper return to an annual 4.3%. Managing money in the real world carries a price tag, of course, although the price can vary, depending on who’s running the show. Indeed, the 1,700 multi-asset class funds in Morningstar’s database have expense ratios ranging from as low as 13 basis points up to nearly 500 basis points. By comparison, our ETF-based version of our proprietary GMI benchmark has a weighted average expense ratio of just 35 basis points.
Does a higher expense ratio bring a higher return? Sometimes, but not always. There are a bit more than 1,000 multi-asset class funds with track records of five years or more, according to Morningstar. Of those, the range of annualized five-year total returns peaked at 14.5% and bottomed out at negative 4.7%. In other words, roughly one-quarter of those 1,000 funds beat our ETF-based version of GMI over the past five years. That means that 75% of the funds delivered trailing performance.
To be fair, there’s a wide variety of strategies practiced in those 1,000 funds and so comparing the results to our benchmark may be a stretch in some cases. Indeed, these funds collectively are doing virtually everything under the sun. Some are quite tame bordering on passive while others are trading broad sectors and asset classes quite furiously. In any case, GMI makes no assumptions and instead owns and holds everything in weights according to market values. As such, it’s a fully transparent and uncomplicated strategy that’s available to everyone because it requires no expertise or trading skill. And at a cost of 35 basis points, it’s one of the least expense ways to dive into a broad asset allocation strategy.
Should you do something else? Perhaps. In fact, almost everyone does. But deciding how to do something else by way of picking from the prepackaged asset allocation fund choices isn’t easy. In fact, it’s fraught with a number of hazards. That doesn’t mean you should avoid these funds. There are, in fact, some good choices. Finding them, however, takes time, effort and a bit of skill in separating the strategic wheat from the chaff.