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For additional information, contact:
Chip Norton Managing Editor S&P Personal Wealth 24 Hartwell Avenue Lexington, MA 02173-3103 (781) 860-6513 chip-norton@mcgraw-hill.com |
One of the most powerful ways to harness the advantages of mutual funds is through asset allocation: putting them in portfolios providing exposure to market sectors that will meet a particular goal. While this sounds simple enough, asset allocation provides far more than a mix of a few good funds. The combinations of funds and allocations to those funds in a portfolio are almost limitless, and the benefits of risk reduction can be tremendous. However, because of the many types of investor objectives, available funds and allocations, there is no perfect or “insight” asset allocation. Each allocation and fund selection should best meet an investor's specific objectives. As a starting point, asset allocation has been around as long as the ability to invest. As soon as someone discovered that holding just one security excluded them from the benefits of others, allocation in its most basic form was born. Mutual fund allocation started with the first mutual funds in the 1920s. The original concept of a mutual fund was to pool various securities into one fund and offer it to the public. In this way, an investor could increase his or her exposure to many different companies under one investment roof. In the beginning, allocation mainly consisted of securities in the same asset class, generally the blue chip stocks. While this type of fund provided diverse exposure to the equity market, it focused on just one segment of investing -- growth. Soon after the first funds appeared, others were offered that combined both bonds and stocks. These funds provided both growth and income under one roof. The idea that unique asset combinations could provide more that just a diversified portfolio in one sector had caught on. But there was more to come. As more and more portfolios were offered to investors, it became apparent that there was yet another benefit of diversification beyond a simple combination of assets. A portfolio’s overall risk could be reduced by mixing and matching securities that moved in opposite directions. This was the discovery of Harry Markowitz in the 1950s and 1960s. His work, which led to a Nobel Prize for Economics in 1990, showed that combining securities that had low correlation to each other could reduce the volatility as measured by the standard deviation of the portfolio. While his work was complicated, it eventually became one of the most powerful tools in modern portfolio management and in the fund allocation process. As an example of the power of Markowitz’s work, let’s look at a two-fund portfolio. The two funds are both aggressive growth ones with standard deviations of 25% and three-year total returns of 30%. Clearly, these two aren't headed for a conservative investor who can't stand volatility. Or are they? While the simple average return of the two funds would be 30% and the simple average risk would be 25%, the actual risk of the portfolio could be far less than even the most conservative bond fund. But how can that be? The answer lies in the return relationship between the two funds. If Fund A gains 10% in month one, while Fund B drops 10% in month one, they are said to be perfectly negatively correlated. In other words, as one goes up, the other goes down. The end result is that the standard deviations of the two funds will "net" each other out. Over time, the returns of the two funds will increase, but out of synch with each other. This still allows the two to achieve the 30% over the three years, but the risk the portfolio experiences will decline dramatically. Of course, in the real world there are few funds that move in perfectly opposite directions, but there are many that are at least mildly uncorrelated. Matching these securities in a portfolio can produce significantly less risk than any one of the funds can individually. Taken a step further, a portfolio manager who employs this sophisticated technique can reduce his or her portfolio even though they may own several volatile securities. |
