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Rebalancing Critical as Volatility Rises

As a client takes distributions, a money manager ultimately becomes more important than asset allocation as the sequence and volatility of market returns rises.

That's according to a report from Jim Otar, a Thornhill, Ontario, Canada-based financial analyst. Otar's analysis tracks 111 years of market history. The paper, "Determinants of Growth in Distribution Portfolios: A Non-Gaussian Analyis," is available on Otar's website at

Conventional decision-making advocating asset allocation is based on a study published by Gary Brinson and others in 1995 in the Financial Analysts Journal. That research revealed that asset allocation contributes 94% to the performance of a portfolio. Security selection contributes just 2.2%, while luck and market timing are responsible for the rest of the return. The study was based on the portfolios of 91 pension funds with over $100 million in assets from 1974 through 1994.

Since 1995, "many in the financial planning profession have tried hard to make investors believe that asset allocation is the Holy Grail of investing," Otar said. "When a new account is opened, the first thing a client does is fill out a risk-assessment questionnaire. Based on the client's answers, he or she is pigeonholed into one of four or five investment portfolios. We do not believe this is the right approach."

Especially when people are about to retire, Otar said many money managers mistakenly make decisions based on that Brinson study. However, cash flow into a pension fund is ongoing. By contrast, cash flows out of individual accounts continuously during the distribution phase. During periods of rising inflation, contributions into pension funds typically rise due to wage increases. Meanwhile a withdrawal percentage from individual accounts may increase to keep pace with the cost of goods and services. In addition, the Brinson study results reflected one of the best 20-year periods in stock market history-from 1974 through 1994.

Otar analyzed market conditions over the 111 years from 1900 through 2010. He calculates the historical asset values of all portfolios since 1900 as if a scenario starts in each of the years between 1900 and 2000. The method, he said, reflects the sequence of returns exactly as it happened. This results in calculations of success or failure statistics based on actual historical performance-not statistical simulations.

He evaluated the impact of asset allocation based on five different portfolio mixes ranging from 100% in stocks to a mix of 20% in stocks and 80% in fixed income.

For stocks, he used the S&P 500 Index. Fixed income net returns were calculated, after expenses, based on historical six-month CD rates plus 0.5%. That corresponds approximately to a fixed income portfolio with a five-year to seven-year maturity.

Otar also factored in systematic withdrawals ranging from 0% to 10% from portfolios. He then determined the impact of sequence and volatility of returns, inflation, rebalancing frequency, portfolio cost and the potential alpha that might be produced by better management decisions.

The results of his study show, for example, that based on a 4% withdrawal rate, sequence and the volatility of a portfolio return can contribute 32% to the total return of the entire portfolio. Inflation can contribute 21%, asset allocation, just 20% and money management skills, 11%.

The study suggests the important role a financial adviser can play in setting up the right portfolio-and making adjustments due to the volatility of the financial markets.

"We observe that by far, the most important factor across all withdrawal rates is the sequence and the volatility of returns," he said. "As withdrawal rates increase and the portfolio life shortens, the importance of asset allocation diminishes and is replaced by the effect of inflation."

Otar's study does not factor in the impact taxes into his equations. Some analysts would argue that Monte Carlo simulations, which test thousands of possible results, are a better way to evaluate the data. Like the vast majority of investment performance research, his study does not take into account asset-weighted returns. Instead, performance is based on actual dates and times people invest.

Despite these omissions, other money managers believe Otar is on the right track.

Greg Womack, an Edmonton, OK-based money manager said that asset allocation is the keystone to money management. But he says it needs to be adapted to real-word experiences. In this day and age, people need plenty of cash. That can't be factored into the return per unit of risk in a portfolio. He uses a model that makes automatic changes in portfolio allocations when assets increase 5% or 6% in value. He also will tactically add alternative investments to some client portfolios as a hedge.

"It is a safer way to invest than buying and holding," he said. "Moderately rebalancing has improved my clients' risk and return. Some clients need at least six months of cash on hand. In the future, they many need more cash. You can't factor that into their portfolio's risk and return."