Research Review | 8.29.2011 | Asset Allocation

Seasonal Asset Allocation: Evidence from Mutual Fund Flows
Mark J. Kamstra, et al. | Working Paper | August 1, 2011
This paper explores U.S. mutual fund flows, finding strong evidence of seasonal reallocation across funds based on fund exposure to risk. We show that substantial money moves from U.S. equity to U.S. money market and government bond mutual funds in the fall, then back to equity funds in the spring, controlling for the influence of past performance, advertising, liquidity needs, capital gains overhang, and year-end influences on fund flows. We find a strong correlation between mutual fund net flows (and within-fund-family exchanges) and the onset of and recovery from seasonal depression, consistent with the hypothesis that investor risk aversion varies with the seasons. Further, we find stronger seasonality in Canadian fund flows (a more northerly location relative to the U.S., where seasonal depression is more severe), and a reverse seasonality in fund flows for Australia (where the seasons are reversed). While prior evidence regarding the influence of seasonal depression on financial markets relies on seasonal patterns in asset returns, we provide the first direct trade-related evidence.

Re-Thinking Target Date Funds
Andrea Malagoli | Buck Consultants | August 2011
There is growing consensus that Target Date Funds (TDFs) represent a “better” solution for retirement investing than traditional strategic portfolios like a 60/40 equities/bonds. While much marketing material hints at the fact that TDFs may provide a “safer” or “less risky” solution for retirement investing, these claims appear to have been contradicted by recent empirical evidence during the 2008 market downturn. In this article we examine the conceptual design behind Target Date Funds (TDFs) in the context of a rigorous modern finance theory framework. In particular, we analyze the risk/return properties of the “glide path”, a defining feature of TDFs, and compare them against the various claims singling TDFs out as “the” ideal solution for defined contribution retirement plans. Not surprisingly, it can be formally demonstrated that the deterministic (time based) design of “glide paths” does not necessarily improve the risk/return characteristics of retirement portfolios, and that TDFs are a riskier form of investment than commonly believed. We make the case for a complete and consistent framework to vet the risk-and-return proposition of TDFs. In particular, financial operators and regulators should re-examine the existing TDF solutions and encourage more accurate disclosure of the expected risks and returns of each product in a manner consistent with (a) rigorous analysis based on commonly accepted financial theory and (b) realistic empirical market evidence.
Rebalancing with Spending and Illiquid Allocations
Martin Leibowitz and Anthony Bova | Morgan Stanley | July 13, 2011
Our previous reports that focused on rebalancing liquidity were limited to a discussion of 60/40 portfolios. This report adds both illiquid investments and net flows to the rebalancing equation to provide a more comprehensive analysis of the relationships between rebalancing liquidity, portfolio flows and diversification into illiquid assets. Spending programs and allocations to illiquid assets (non-equity, non-fixed income) naturally reduce a fund’s overall liquidity, but they may also — somewhat surprisingly — lower the cash required for rebalancing. However, over multi-year horizons, spending costs can dominate the rebalancing effect and drive a portfolio’s fixed income reserves down to a level that many investors would find hard to tolerate.
Can Large Pension Funds Beat the Market? Asset Allocation, Market Timing, Security Selection and the Limits of Liquidity
Aleksandar Andonov, et al. | Working Paper | July 14, 2011
We assess the three components of active management (asset allocation, market timing and security selection) in the performance of pension funds. Security selection explains most of return differences. On average, the large pension funds in our sample provide value to their clients using active management, after accounting for all costs, both before and after risk-adjusting, and using all three components of active management: with an annual alpha of 16 basis points from asset allocation changes, 27 basis points from market timing, and 45 basis points from security selection. All three components exhibit significant liquidity limitations, which seem quite important even for asset classes such as equity and fixed income. Security selection outperformance is further driven by momentum trading, which we do not consider as a priced factor and which accounts for about 72 basis points annual alpha. Larger funds realize economies of scale in only in their relatively minor investments in alternative asset classes like private equity and real estate, while thus experiencing liquidity-related diseconomies of scale in equity and fixed income.
Risk Parity Portfolio vs. Other Asset Allocation Heuristic Portfolios
Denis Chaves, et al. | The Journal of Investing | Spring 2011
In this article, the authors conduct a horse race between representative risk parity portfolios and other asset allocation strategies, including equal weighting, minimum variance, mean–variance optimization, and the classic 60/40 equity/ bond portfolio. They find that the traditional risk parity portfolio construction does not consistently outperform (in terms of risk-adjusted return) equal weighting or a model pension fund portfolio anchored to the 60/40 equity/bond portfolio structure. However, it does significantly outperform such optimized allocation strategies as minimum variance and mean–variance efficient portfolios. Over the last 30 years, the Sharpe ratios of the risk parity and the equal-weighting portfolios have been much more stable across decade-long subperiods than either the 60/40 portfolio or the optimized portfolios. Although risk parity performs on par with equal weighting, it does provide better diversification in terms of risk allocation and thus warrants further consideration as an asset allocation strategy. The authors show, however, that the performance of the risk parity strategy can be highly dependent on the investment universe. Thus, to execute risk parity successfully, the careful selection of asset classes is critical, which, for the time being, remains an art rather than a formulaic exercise based on theory.