In last week’s MoneyWeek magazine, Merryn Somerset-Webb interviewed Alan Miller, a successful fund manager. In the interview Merryn remarked that “endless studies show that it is asset allocation that makes the difference to most portfolios”.
Miller makes no attempt to differentiate a good share from a bad one, but simply makes decisions between ‘asset classes’. In other words, he will commit his clients’ money, in certain proportions, to UK bonds, overseas bonds, US equities, emerging markets and UK small companies, etc. He will try to add value by altering the proportions held in each asset class without making any attempt to add value within them by, for instance, selecting good shares over bad ones.
Today, I will show you why I think this notion is self-serving nonsense. It is simply a conceit put about by the big fund managers and is entirely detrimental to the efforts of private investors.
How can I say so when Merryn’s “endless studies” have shown otherwise?
What happens when you split two asset classes?
Let me simplify the matter.
Suppose a big fund manager splits his portfolio between two asset classes, Japanese equities and US equities. Let’s also say that, as most fund managers do, he has a very large number of individual shareholdings – I’ll say 100 in each market. What the proponents of asset allocation will tell you is that, instead of worrying about each individual share, you should worry about whether the Japanese market will outperform the US market or vice versa.
Now, suppose that the US market rises by 10% and the Japanese market falls by 10%. And there is a further 10% appreciation of the dollar against the yen. That gives a 30% outperformance of the US equity market versus Japan. The smart fund manager will have been ‘overweight’ in US equities, and however well his Japanese shares may have done relative to the Tokyo index it is inconceivable that they could have made up for this 30% market swing.
Fair enough. But the reason that stock selection cannot make up the difference is that the fund manager holds so many shares. Furthermore these are probably representative of the index and move in line with it.
Why would you want to own 200 shares?
So now suppose that instead of holding 100 US shares and 100 Japanese shares our fund manager holds just two in each market. Then it becomes entirely possible that he might, by picking great Japanese companies, make more from his Japanese shares than his US shares, regardless of how the indices move.
Fund managers love to talk about the importance of asset allocation because it plays to their perceived strengths. They employ economists and strategists, who are able to keep track of the global economy in a way that we individually cannot. So it suits them to tell us we need to be investing globally, even though there is really no need at all. Next they like to claim that, from their lofty intellectual vantage point, they are rather good at predicting the path of the global economy and the world’s financial markets, even though I have never seen any evidence that this is so.
What’s really wrong with asset allocation?
But the main reason they peddle the asset allocation line is that, due to the huge amount of money they manage, they have no option but to hold vast numbers of individual shares. The impact of any one share, however good or bad, is going to be so insignificant that it can never offset index swings that affect maybe 20%-30% of the portfolio simultaneously.
There are two more reasons why the asset allocation argument is disingenuous. First of all, a share index only consists of its underlying corporate constituents. So assessing the companies individually on a ‘bottom-up’ basis should lead you to the same conclusion as the ‘lump them altogether into one’ top-down asset allocation approach.
Finally, be under no illusion that asset allocation is just gambling by another name. For every fund manager who goes long of Japanese equities, another is going short. Some will get it right for a while, but others will get it wrong and in aggregate all they will do is swap assets while of course charging their clients for this activity.
Asset allocation is a game played by fund managers because they know no other. But we private investors have no need and should not act like this.
We can afford to be very selective, to pick only shares in great companies and ignore everything else. This, by the way, is much, much easier than attempting to predict global markets. And maybe it explains why the world’s most successful investor is an old-fashioned stock picker from Omaha, Nebraska.