An Asset Allocation Model
Understanding Asset Allocation by Victor Canto
An asset allocation model is provided by Victor Canto in his book titled Understanding Asset Allocation: An intuitive approach to maximizing your portfolio
Canto argues that there is a time for everything.
"There is a time for active management and a time for passive management: a time for value stocks and a time for growth stocks; a time for large-caps and a time for small-caps".
As investment cycles persist, he claims that there are times when each strategy outperforms. In his view, there are signals that can correctly anticipate the turning points in the various cycles, when one approach can out-perform another.
He describes this asset allocation model as a value-timing approach to asset allocation as distinct from a market-timing approach.
He used a periodic table of asset returns consisting of seven asset-class returns with data from 1975 to 2004.
Using the data, he discovered that a strategic asset allocation can deliver average performance over a long time period, but because it does not rotate among the various asset classes, this allocation cannot capture the upturns that the best performing asset classes at any period in time can deliver.
He further found that a cyclical asset-allocation strategy that tilts around (strategic) benchmark weights in direct proportion to an outlook's conviction is superior to a strategic asset allocation strategy.
Optimal Asset Allocation
Economic drivers, such as the inflation rate, that he claims should affect asset choices, and which should be used to inform a cyclical asset allocation strategy, are outlined below.
The asset class of choice depends on whether the economic driver is rising or falling ...
- Inflation rate - if rising: T-bills; if falling: T bonds (T = Treasury)
- Real interest rates - if rising: equities; if falling: T-bonds
- Inflation, taxes & regulation - if rising: small-cap stocks; if falling: large-cap stocks
- Inflation induced tax bracket creep - if rising: value stocks; if falling: growth stocks
- Foreign exchange value of the dollar - if rising: domestic stocks; if falling: foreign stocks
Canto's cyclical strategy is to tilt the portfolio asset allocation in the direction that the particular economic driver is signaling.
Application of a Cyclical Allocation Strategy
Canto's strategy, while well argued and backed up by decades of data, would only appear to be suitable for a portfolio of mutual funds representing the different asset classes he discusses.
Why? If a portfolio contains individual stocks, moving the allocation between large-caps/small-caps, domestic/international, and value/growth over the market cycle would be a logistical nightmare.
The other concern is how one defines the different asset classes. Many domestic stocks may have a varying international component. Many value stocks have a growth component.
By using mutual funds, one assumes that he is leaving it to each fund manager to determine what is value and what is growth, and and what is domestic and what is international.
For investors whose equity allocation consists of individual stocks, Canto's asset allocation model may not be fully useful, since they are unlikely to hold a sufficient number of stocks to be re-weighting between large/small, value/growth and domestic/international.
Where the asset allocation model may be useful for the average investor is in the cyclical allocation between equities as a whole and T-bonds and T-bills.
From a value investing
perspective, it is interesting to note that in the 1995-2004 time period, Canto concluded that value stocks would have been the best choice over these three decades.
While small-cap stocks had a greater return, their volatility was significantly higher.
Asset allocation funds - are single mutual funds that allocate funds across a range of asset classes and make the job of asset allocation easier. Worth a look?
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