Asset Allocation

Never Having to Say You Are Sorry Mark S. Kent, CFP, CFA President, Portfolio Strategies Advocis Wealth Weekend August 20, 2006

Asset allocation deserves more thought than this

One of our most popular funds Another popular fund Another fund for good measure Wild Card

“As a matter of fact, yes I was on drugs when I created your financial plan.”

FRC Study

(28 February 2002?) “Predicting Mutual Fund Performance – Examining the Predictive Utility of Popular Mutual Fund Screening Criteria” www.frcnet.com/frc_home.asp

#1 - Past Performance

•Question - Will best performing funds over the past 1, 3 or 5 years be the best performing over the next 1, 3, or 5 years? •Evidence - For U.S. equities – 0 (no predictive ability) - For Int’l/Global – 2 (moderate) •Conclusion - Future out-performance appears unpredictable on this definition of past performance (1 – 5 years)

#2 - Morningstar Ratings

•Question - Do 4 or 5-Star Morningstar rated funds provide future out-performance? •Evidence - U.S. Equity – 0 (no predictive ability) - International/Global – 0 (no predictive ability) •Conclusion - Morningstar ratings do not appear to be a good predictor of future out-performance (1 – 5 years)

#3 - Standard Deviation

•Question - Do funds with higher standard deviation provide future out-performance?

•Evidence - U.S. Equities – 2 (moderate) - Int’l/Global – 0 (no predictive ability) •Conclusion - Standard Deviation does not appear to be a good predictor of future out-performance (1 – 5 years)

#4 - Sharpe Ratio

•Question - Do funds with higher Sharpe Ratios outperform in the future?

•Evidence - U.S. Equity – 0 (no predictive ability) - Int’l/Global – 2 (moderate) •Conclusion - Sharpe Ratio does not appear to be a good predictor of future out-performance (1 – 5 years)

#5 - Beta

•Question -Do funds with a higher beta outperform in the future?

•Evidence -U.S. Equity – 2 (moderate) -Int’l/Global – 0 (no predictive ability) •Conclusion -Beta does not appear to be a good predictor of future out-performance (1 – 5 years)

“You must be the fellow who asked to see one of the clowns who runs our fund’s research department.”

What is Risk?

•Interest Rate Risk •Inflation Risk •Currency Risk •Risk of Outliving Your Capital •Risk of Not Meeting Short Term Financial Goals •Portfolio Volatility

Prospect Theory

•Clients treat gains and losses differently – 2X •They may not be risk averse – rather loss averse •They are reference dependant Recommended Actions: •Acknowledge the emotional impact of losses •Check for loss aversion •Set specific goals and keep the focus on it •Think long term

“Risk taking comes from being irrationally optimistic” “Experts are very good at explaining the past, but lousy at predicting the future” “People think too small (framing is too narrow), hence they have a short time frame of one year, rather than focusing on the long term” Dr. Daniel Kahneman Princeton University September 2004

• • •

The Basics of Asset Allocation

Most important decision in managing a portfolio Stocks, bonds, cash equivalents for most clients Brinson, Hood, and Beebower Study (1986) of 91 pension plan returns for 1974 to 1983 found that the asset mix explained 95% of the variability in quarterly returns

Different Types of Asset Allocation

• • •

Strategic

– Longer term focus-through a market cycle

Tactical

– Review expected Asset Class Returns and rebalance portfolio towards assets with highest expected relative returns. “Sell Winners, Buy Losers”

Dynamic (Portfolio Insurance)

– maintain some minimum level of return or asset value; margin of safety. Buy risky assets in rising markets and sell them in falling markets. Value of strategy debatable.

Asset mix decision is a three step process:

1.Quantifying expected risk and return by constructing an efficient frontier 2.Quantifying the investor’s risk tolerance and preferences 3.Finding the optimal portfolio

Modern Portfolio Theory (MPT)

• Rationale is to obtain the best possible expected return given the level of risk assumed • Process is to minimize the risk of the portfolio for each level of desired risk and return combination • Combine assets that are not highly correlated • Measure the extent to which pairs of asset returns are likely to move together

What is an Efficient Portfolio?

• For a given level of expected return, there is no portfolio with a lower risk • For a given level of risk, there is no portfolio with a higher expected return

Pitfalls of Mass Market Asset Allocation

• No customization (“Don’t like Asia, want to keep my strip bonds”) • No control of fees, MERs • No ROR objectives, nor is downside risk explicitly stated

• Using historical RORs to build portfolios (Monday morning quarterback) • Perception of client that they may be supporting sales of 3 rd or 4 th quartile managers • Six foot wave analogy • Won’t hit home runs, no sex appeal

Questionnaire driven models are flawed If you do a retirement plan for your client aren’t the rate of return and “smoothness of ride” the most important?

Previous Challenges

• Weird Science (70% Futures, 30% Health Care) • Most of us are trained to sell equities • Foreign content limits • Juice it with Canadian Small Cap instead of Large Cap Dividend that model called for (asset allocation doesn’t work?) • Convincing advisors to include bonds

Bonds vs. Equities

• Over the past 60 years annual equity returns (S&P 500 TRI) have been negative 23 percent of the time • If Investors evaluate their portfolios frequently, say monthly, equities underperformed bonds 42 percent of the time over past 60 years • On an annual basis, equities underperformed bonds 32 percent of the time (over 5 year periods, equities underperformed only 17 percent of the time)

Current Challenges

• How often to rebalance • Reporting challenges, client needs • Income trusts (sex appeal) • Why am I not in gold, oil, etc.

• Selling winners to buy losers. Intuitively difficult, not always right (tech), but usually is right • Not able to look at Portfolio as a whole (Hung up on one loser, not seven winners) • Defining a market cycle for clients (not 1 yr)

“New Frontiers in Rebalancing: Guidelines for Planners” By Gobind Daryanani iRebal

Rebalancing Options

“Buy Sell” Opportunities (offensive, alpha chasing) vs Traditional Drift Correction (defensive)

You do get alpha (compensation) for doing the extra work (0.50% per year) Reviewing portfolio mix every two weeks is okay

Top 10 Conclusions

1. Avoid rigid calendar rebalancing (Dec. 31, Qtr end, Semi-annually) 2. Look frequently 3. Use wider bands (20% of asset class weight) -Don’t want to cut off momentum 4. Rebalancing wins over trading costs 5. Rebalancing wins over realizing gains

6. Use more asset classes (uncorrelated) 7. More frequent withdrawals of cash for income needs 8. Locate assets efficiently (do not use pro rata) 9. Trigger on class target, honour sub/fund 10. Use lot level rebalancing

Long-Run Planning, Short-Term Decisions: Taking the Measure of the Investor’s Evaluation Period by Ena Garmaise, Ph.D.

Journal of Financial Planning, July 2006 http://www.fpanet.org/journal/articles/2006_Issues/jfp0706-art8.cfm

• Client’s investment time horizon is not the same as the evaluation period over which clients measure their investment results in order to decide on the success of their strategy • When asked how long they would wait before deciding to change their investment strategy, half of respondents report having an evaluation period longer than two years. If faced with a 5 percent decline in their portfolio in the previous year, the decision time frame shortens for 40 percent of respondents

• Investors under 40 showed greater patience than older investors. Men in their fifties are considerably more impatient. Evaluation period shortens significantly for people in their sixties and thereafter (pattern among women is more gradual) • Clients with aggressive goals often have relatively short evaluation time periods

Think Differently

Our Approach

• “Best of the Best” Managers (Clients love this) • Predictive downside (90, 95, 99% probability) • Healing a sick portfolio (Predict ROR, downside solve for need at lowest volatility) • DSC Dilemma. Clean slate with big DSC hit, or partial, gradual fix with free and matured units (less insulting to client).Why are your ideas better than the last 3 advisors!

• Rebalance each time new contributions are added • Stick with asset mix (Don’t make sector or capitalization bets)

Implementing a well-conceived strategy for clients and having them adhere to it will help avoid many of the common financial planning pitfalls. In turn, financial planning can prevent clients from falling into mental traps that will likely sabotage their financial success.

– Charles H. Brandes, CFA Chairman, Brandes Investment Partners & Co.

Chairman of the Executive Committee, Brandes Investment Partners LLC

New Opportunities

• High Interest Accounts • Cashable GICs • Principal Protected Notes • Introduction of Hedge Funds (BluMont) • Managed futures not correlated to equities or fixed income

Food for thought

If you miss an opportunity but preserve your capital, there will be another opportunity. If you lose your capital, you will miss all future opportunities.

Questions?

Mark S. Kent, CFP, CFA Portfolio Strategies Corporation Suite 301, B6 2509 Dieppe Ave. S.W.

Calgary, AB T3E 7J9 T: 403.252.5222

[email protected]