Asset allocation is a critical factor in performance

I recently attended an interesting discussion: "Who needs an investment manager?" and "What is an investment manager's role, in general?"

I recently attended an interesting discussion: "Who needs an investment manager?" and "What is an investment manager's role, in general?"

The discussion showed that a crucial role of an investment manager is asset allocation. This conclusion concurs with almost all studies that asset allocation is the most influential factor in a portfolio's performance over time, and upholds long-term investment goals. Active allocation will account for at least 90percent of an investment's performance.

A fundamental problem is how to classify assets into different groups (asset class) or more accurately - what is the definition of an "asset class"?

In an article, George Oberhofer of firm Frank Russell says hedge funds are not an asset class of themselves. An asset class is not an investment instrument and this misconception might prevent the portfolio from being properly diversified.

Without defining asset class, we were interested in the factors that are relevant for defining an asset class. These factors are:

1. Securities included in the class should be more conceptually similar to each other than to securities excluded from the class;

2. Returns of securities included in the class should be more highly correlated with each other than with returns of securities outside the class;

3. Asset class should represent a substantial fraction of the existing investment opportunity set;

4. Price and composition data should be readily available;

5. It should be possible to invest in the asset class passively.

Important factors are the similarity of characteristics, correlation and the weight of the asset class in relation to the sum of the existing investment opportunity set. This definition sharpens the distinction between an asset class and a financial instrument since there could be different investment instruments with exposure to the same basic asset, and so the result might be similar characteristics of behaviour and a correlation in performances.

Another interesting approach is that of Bernard Winograd, president and chief executive of Prudential investment firm, as illustrated in his article in which he deals with "alpha" and "beta" indices in the process of asset allocation. Beta is the level of exposure to the market's volatility, meaning how much yield can be achieved from the exposure to the market in itself. Alpha is the risk-adjusted excess return that the manager generates in comparison to the yields the market generates.

A possible definition for asset class is assets of a similar beta, meaning assets that behave similarly when compared with the market. The problem with this definition is one has to define what the market is. The aim of the exercise is creating a better mix in the portfolio. An incorrect definition might cause an illusion of diversification rather than true diversification.

l The writer is a director of Pioneer Financial Planning. Visit or e-mail