Asset Allocation Don'ts
The picture in the header of this post is of the various inlets and outlets on back of the Scania firetruck from the Bondi Beach station of New South Wales Fire & Rescue and is a pretty good metaphor for what most people's asset allocation should look like. The motivation for today's post was this chart shared by Barry Ritholtz;
We've talked countless times about the extent to which endowments and similar pools of capital that have huge allocations to alternatives and the apparent drag on results from those large allocations as equities have rocketed higher over the last ten years. I am a huge believer in taking bits of process from others to create your own process, to learn from these pools of capital but not necessarily to emulate them. Endowments have what amounts to an infinite time horizon and family offices typically manage dynastic wealth and chances are neither scenario applies to you.
My interest/intrigue in alternatives came from the first time I read about former Harvard Management Company CEO Jack Meyer and his reasoning for owning timberland (this might have been in the 90's). The influence then is my moderate use of alternatives over the years to manage volatility especially when the S&P 500 is below its 200 day moving average (DMA). With market indexes moving higher I still have a little exposure to alternatives but less than I had back in Q4 of last year into the start of 2019.
The difference between too much exposure, like the 46% above and little to no exposure is the difference between missing a huge rally like we've had so far this year and missing it. Yahoo Finance has the S&P 500 up a little over 16% YTD and while the line between missing and lagging is subjective, it would be a difficult conversation if an advisory client thought he had a "normal" allocation to equities and what he thought was the equity portion of his portfolio was up 4% in an up 16% world.
Not everyone needs a "normal" allocation to equities to have their financial plan work out but if you do but you currently don't, then you might have a problem at some point. What makes the picture a decent metaphor is that the middle inlet could be thought of as the equity allocation in a normal portfolio, the largest allocation which might mean 50% or 60% or even 70% but probably not 20% or 30%, again assuming that your financial plan is relying on stock market growth.
Managing an endowment or protecting dynastic wealth may not rely on stock market growth. Hearing that such and such university's endowment lagged the S&P 500 by x% in some random year is not really enough information. A $10 billion endowment might have to pay out $500 million a year but maybe they reliably take in $375 million in alumni donations. If that scenario exists anywhere, then how much equity exposure would that endowment need? Sure in hindsight of the last ten years more would have been better but 30% in equities could be suitable. The point is not to defend endowments but to point out their needs are different. Maybe they are coming up short, maybe not but it is unlikely that you know, I certainly do not unless I read something from them saying they came up short of their expectations. Underfunded pensions are probably a different story. There are a lot of problems and over the years a lot of good salesmen and consultants convinced decision makers they need more alternatives.
It is very unlikely that you need more alternatives. A sentiment I've shared many times is that equities are the asset class that has historically gone up the most. The more you allocate away from equities, the greater your opportunity costs. One role bonds play is to help mitigate normal equity market volatility and modest exposure to alternatives does the same thing, you're hedging an equity portfolio with a small exposure to alternatives. Too much in alternatives and you're hedging an alternatives portfolio hedged with a small exposure to equities.