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The Cost of AA Programs
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The Professional Financial Advisor
Toronto-based Financial Advisor John De Goey offers thoughts about fee-based advice, holistic planning and capital markets.

By John De Goey  | Tuesday, May 03, 2005

The thing that is most striking about these programs is that they almost exclusively use higher-cost actively managed funds as the portfolio building blocks.

If asset allocation explains nearly everything about variance, it logically follows that security selection explains nearly nothing. For about a decade now, various investment companies have been cranking out marketing material quoting the academic work done in the 1980s and 1990s done by a team of researchers led by Gary Brinson and studying asset allocation and variance for large US pension funds. Most get it wrong.

Brinson’s research is perhaps the most misquoted and misunderstood research in the history of capital markets research. If the findings could be summed up in one sentence, it would likely be that asset allocation explains over 90% of portfolio variability in returns on average. Two observations pop up. First, the study’s primary finding is about variability, sometimes called standard deviation and referred to as “risk”. Second, the phrase “on average” acknowledges that there are times when the actual experience may be considerably better or considerably worse.

Brinson suggests that active management (security selection) has no measurable impact on variance. Our trusted product manufacturers drone on about what asset allocation does explain without ever referencing what it doesn’t.

Here’s what Gary Brinson himself has said about the matter: “Our study does not mean that if you got a return of 10%, then 9% is due to asset allocation. What it means is that if you looked at the ups and downs and zigs and zags of your portfolio across time, I could explain on average 90% of those zigs and zags if I know your asset allocation. But I can’t tell you anything about the return you’ll achieve.”

This research is most often used in support of wrap account products that aim to optimize risk-adjusted returns by assigning clients an off the shelf portfolio that offers an asset mix that is purportedly customized to the client’s unique circumstances. Product manufacturers usually have four to eight model portfolios available and clients end up in one of those models based on the answers they give to a relatively generic questionnaire.

The thing that is most striking about these programs is that they almost exclusively use higher-cost actively managed funds as the portfolio building blocks. Actively managed funds are not only more expensive, they also tend to have higher portfolio turnover and tend to be at least somewhat impure, so that the prescribed asset allocation is often not the actual asset allocation. As such, active funds could materially compromise the asset mix.

Separate research by Bill Sharpe and others has repeatedly shown that most active managers lag their benchmarks. If the product manufacturers genuinely understood and believed both pieces of research, they would at least consider using cheap, pure and tax-effective index products in the construction of their portfolios. Instead, most products go half way. Consumers are fed selective information that maximizes corporate profit (Brinson on variability) without being told about other material aspects that might harm profit (Sharpe on return).

In a court of law, people are required to tell the truth, the whole truth and nothing but the truth. Meatloaf once said “two out of three ain’t bad”. We can now go to regulators and politicians and ask them to insist that there be more complete disclosure in prospectuses, too. Cherry picking material facts should not be tolerated in a profession where the practitioners are expected to put the client’s interests first.


John J. De Goey is a Senior Financial Advisor with Assante Capital Management Ltd., member CIPF and author of The Professional Financial Advisor. The views expressed here are the personal opinions of the author and not those of Assante and are not endorsed by Assante in any way.

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