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When Asset Allocation Doesn't Work

When Asset Allocation Doesn

When Asset Allocation Doesn't Work

By Ronald L. DeLegge, Editor of ETFguide.com - April 4, 2007

 

The virtues of asset allocation are being erased every single day by the insidious behavior of Wall Street's largest money managers. Are you a victim?

 

For example, certain mutual funds with billions under their supervision purport to be actively managed, but their performance and risk metrics so closely ape corresponding indexes there's hardly a difference! Who in their right mind would pay higher expenses to own an imposter when real index funds can be had for a fraction of the price? The world's best asset mix cannot overcome the negative impact of closet index funds that rob performance by overcharging.

 

What about style drift?

 

This happens when a money manager deviates from a fund's investment objective to pursue another course. It's like breaking the rules in the middle of the game.

 

And it's a quite frequent occurrence too.

 

It's not uncommon to find so-called value funds owning growth stocks and vice versa. In fact, style drift is so dangerous it's even perverted fund classifications. Mutual funds erroneously categorized as domestic funds often have significant holdings in foreign securities. How could it be?

 

But wait, it gets worse. 

 

World class money managers are succumbing to the style drift disease.

 

Some years ago, Bill Miller the famed manager of the much heralded Legg Mason Value Trust raised eyebrows by investing in Amazon.com. When besides never has Amazon ever been a true value stock? And how many active mutual funds have phantom outperformance because they've been style drifting themselves to the top? For investors, it's a conundrum. Precise asset allocation is near impossible.

 

Then too, there's superficial window dressing.

 

A 2004 academic study* produced by Northwestern University revealed widespread problems for more than 4,000 U.S. mutual funds.

 

More times than not, the last trading day of each quarter is the busiest. Why? It's largely because of window dressing. In other words, portfolio managers try to make themselves look smart by selling their losers and replacing them with securities that probably performed better. This gives the false impression the fund owned the good performers, when in reality it didn't. Such behavior is damaging to asset allocation and subjects a portfolio to high turnover and needless trading activity.

 

In each of these destructive examples, asset allocation is powerless.

 

Is it any wonder exchange-traded funds (ETFs) have emerged as such popular and powerful financial tools? Like their traditional index fund relatives, they completely eliminate the detrimental impact of mutual funds that closet index, style drift, and window dress. It's good news to know that precise and undisturbed asset allocation does work with ETFs.

 

On the other hand, asset allocation with anything else is a big question mark.

 

*"Do Funds Window Dress? Evidence for U.S. Domestic Equity Mutual Funds", by Iwan Meier and Ernst Schaumburg from Kellogg School of Management, Northwestern University in August 2004

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