Monday, July 12, 2010

Balanced composites ... are they needed?

What is a "balanced manager"? Arguably, they're a manager who (a) claims some expertise in managing two or more asset classes (e.g., stocks and bonds) and (b) has an ability to adjust allocations across these asset classes. Well, what if the manager doesn't control the allocation? What if it's the client who dictates the allocation? In these cases one might argue that the manager isn't actually a "balanced" manager, but rather a stock and bond manager.

I base this statement partly on a perhaps long forgotten document titled "Answers to Common Questions About AIMR's Performance Presentation Standards," dated September 1992 and published by the Association for Investment Management and Research (what is called the CFA Institute today). Here we find the following:
  • Question: "If the client dictates the asset allocation in a balanced portfolio - e.g., 40% equities, 60% fixed income - how should the portfolio returns be reported?"
  • Answer: "If the client dictates the mix, then this portfolio is not a balanced portfolio, because the manager does not have any discretion over asset allocation, which is a main component of return for this strategy. The Standards recommend that these segment returns be included in equity-only and fixed-income-only composites, with cash accurately allocated."
I should mention that with much of what we do, not everyone agrees with this statement. Many situations involve a client who provides the manager with a range, where the manager has discretion to allocate within certain boundaries. But even here, one might argue that the client has taken responsibility for allocation.

The bottom line is that firms can approach these situations in a manner they feel most appropriate. Some firms will treat these accounts as "balanced," although they aren't the one who is "calling the shots" on the allocation; others will declare them separate asset classes that need to be composited within their respective asset class specific composite.

We began working with a new verification client who has a massive amount of high net worth clients who in all cases dictate the allocation: I suggested to them that they don't have to create a multitude of composites that cover all such ranges. Ideally, they should "carve out" the equity and fixed income pieces and put them into their appropriate composites. However, this ability has been made more challenging with the January 1, 2010 requirement that cash be maintained separately. Alternatively, the firm could declare the accounts as being "non-discretionary" (for GIPS(R) (Global Investment Performance Standards) purposes) since, as the AIMR document clearly states, the allocation drives a "main component of return."


  1. Stephen Campisi, CFAJuly 12, 2010 at 8:28 PM

    This is a surprising amount of confusion for something that is quite simple if properly understood in the context of the client. I think the confusion stems from the failure to distinguish between the "strategic" and the "tactical" asset allocation decisions. The strategic allocation is always a "given" of the client and therefore it is not a decision of the manager. This is true for all strategies and products. In the context of balanced portfolio products, then the stock/bond mix is determined by the client's risk tolerance. For example, a conservative client with a short time horizon and a low risk tolerance would select an asset allocation with a relatively low allocation to equity, perhaps a "30/70" allocation to equity vs fixed. Another way of visualizing this is to picture the investor's "utility curve" intersecting with the so-called "efficient frontier" of market opportunities. This causes more highly risk averse clients to select portfolio allocations with a low equity percentage while more risk tolerant clients (younger, longer time horizon, higher return target) to select portfolios with a higher equity allocation.

    As a result, the STRATEGIC asset allocation is always a client-directed mandate. Frankly, that's not different from saying that the client also directs one manager to invest only in large cap, while another invests in small cap and a third invests in foreign equity. These client mandate have NOTHING to do with whether or not these accounts are included in a composite. Of course they should be assigned to composites which represent their respective strategies.

    The manager does have discretion over the tactical strategy, as you correctly indicate, and the degree of manager discretion is usually provided to the manager. So, the manager's use of discretion is always limited - it is never unbounded (that would be a hedge fund.) As such, we see that balanced managers have discretion within the specified boundaries around a strategic target. And the managers have discretion over the sector allocation within each asset class of equity and fixed. And they have discretion over risk level, style factors, degree of diversification and of course issue selection.

    Sounds like quite a lot of discretion. The fact that a balanced portfolio has been described in terms of its strategic asset allocation is no different that describing any other single asset class product. This has absolutely nothing to do with discretion, and there is absolutely no reason why such balanced portfolio should be excluded from composites and treated as carve outs of individual asset class products. That's worse than nonsense - that's a violation of the GIPS standards and a disservice to the clients that the standards are supposed to serve.

  2. Steve, it's always good to hear from someone who does this for a living. I based my comments on the old AIMR Q&A, as I noted. I think this gives firms some flexibility if they feel that they don't have any wiggle room; if they feel that the client is controlling the balance, which is what the Q&A addressed. I agree that if the manager does have a range to work within, then an argument can be made that they have discretion. But the standards (both AIMR-PPS & GIPS) have always allowed the rules to be firm-defined.


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