Allocation Engineering

The allocation of your assets is arguably the most important investment decision in a portfolio. But like diversification, asset allocation is often misunderstood, and therefore not fully utilized. Your allocation needs to take into account many factors, both personal (goals, risk tolerance, etc.) and theoretical (what assets should be included, what is the expected return and risk, etc.).

Using our knowledge of capital markets and Nobel Prize winning financial and economic concepts, we design asset allocations that are engineered for better results. Our asset allocation decisions are driven by five key factors.

Three Equity Factors: Most finance academics and investment professionals acknowledge that there are three primary equity (stock) factors influencing portfolio returns. These three principles are based on the timeless fundamental that risk and return are directly related.


Market:

Stocks have higher expected returns than fixed income (bonds). Most investors expect to receive higher returns from stocks than bonds. Stocks are riskier, but over time, you are compensated for the additional risk. Therefore, the percentage invested in stocks vs. bonds affects overall expected return.
 

Size:

Small company stocks have higher expected returns than large company stocks. Stocks of small companies are riskier than those of large companies. Over time though, you are compensated for this additional risk. The percentage invested in small vs. large affects overall expected return.
 

Price:

Lower-priced “value” stocks have higher expected returns than higher-priced “growth” stocks. Value stocks are riskier than growth stocks. Over time though, you are compensated for this additional risk. The percentage invested in value vs. growth affects overall expected return.
 

The Relevant Factors in Asset Class StructureAverage Annual Returns
Average Annual Returns: 1964-2003.
Equity data courtesy of Fama/French.
Bond data courtesy of © Stocks, Bonds, Bills and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated works by Roger C. Ibbotson and Rex A. Sinquefield).

The chart above shows the out-performance of stocks over T-Bills, Small-cap stocks over Large-cap stocks, and Value stocks over Growth stocks. (BtM stands for "Book-To-Market". High ratios indicate a value stock and low ratios indicate a growth stock.)

Investing is not without risk, but some risks you are compensated for and others you are not. Positioning your portfolio to experience the compensated risk factors and minimize the uncompensated risk factors helps increase your expected return and reduce unnecessary portfolio risk.


Example:

A person who owns an individual large company stock is taking on a lot of unnecessary risks (specific company risk, industry risk, and perhaps interest rate risk and exchange-rate risk). This person is not consistently rewarded for the unnecessary risks. Over time, they are only rewarded for taking market risk.

A person who owns the S&P 500 index is also only rewarded for market risk (since the S&P 500 is not considered small or value). This person, however, has minimized their exposure to unnecessary risks through diversification (500 stocks vs. 1 stock).

We utilize these three equity factors in our portfolio construction to offer a way to capture expected return premiums greater than the broad stock market.

Fixed Income Factors

 

Two Fixed Income Factors: We believe that the role of fixed income in a portfolio is not to produce income, but to reduce portfolio risk (volatility). We consider these two factors.

Maturity:

Longer-term bond investments are riskier than shorter-term bond investments.


 

Default:

Bond investments of lower credit quality are riskier than bond investments of higher credit quality.

Annualized Returns

Quarterly: 1964-2004.
One-Month Treasury Bills, Five-Year Treasury Notes, and Twenty-Year Government Bonds courtesy of Ibbotson Associates. Six-Month Treasury Bills courtesy of CRSP (1964-1977) and Merrill Lynch (1978-present). One-Year Treasury Notes courtesy of CRSP (1964-May 1991) and Merrill Lynch (June 1991-present).

Historical data does not indicate there has been a reliable return premium for extending maturities into longer bonds. Therefore, we emphasize shorter maturities (6 years and under), higher quality bond issues, and a diversified global approach (where currency risk is hedged).

By applying these five factors, we can engineer our asset allocation designs for optimal long-term performance.  To view one of our portfolio designs with explanations on why each asset class is included, please click here.

Once your asset allocation is designed, it is important to implement it with investments that compliment our overall strategy. We primarily use “asset class” funds for implementation. Asset class funds are dedicated to covering a particular risk exposure, or asset class (large value, international, etc.). They are not subject to the style drift and turnover of actively managed funds. Asset class funds also provide much broader, deeper coverage of the chosen asset classes than traditional index funds. DFA Funds offers the best asset class funds. We primarily use them for the implementation of our portfolios.

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